## 1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013

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### II. Debt dynamics and decomposition (end-2007 to end-2013)
- Total increase in debt/GDP ratio (EA18 aggregate): 28.8 percentage points (pps).
- Stock-flow adjustment: 9.4 pps (33% of total increase).
  - Largely financial sector intervention, rescue packages, realization of contingent liabilities.
  - Example: Ireland banking sector rescue increased the debt-to-GDP ratio by 25 percentage points.
  - Bank support costs in some cases amounted to about 40 percent of GDP (with partial financing through financial asset sales).
- Overall deficit contribution: 19.4 pps (67%).
  - Interest rate-growth differential: 11.6 pps (40%).
    - Nominal GDP growth contribution: -5.0 pps (-17%).
    - Interest rate (cumulative interest payments): 16.6 pps (58%).
  - Primary deficit: 7.8 pps (27%).
    - Cyclical component: 5.3 pps (18%).
    - CAPB (cyclically adjusted primary balance): 2.5 pps (9%).
      - One-offs: 1.3 pps (5%).
      - Structural balance: 1.1 pps (4%).
- Key lessons:
  - A substantial portion of the debt increase reflected automatic stabilizers and exogenous factors (bank bailouts, interest bill), not discretionary fiscal stimulus.
  - Countries entered the crisis with insufficient fiscal buffers despite the nominal 3 percent deficit ceiling.

### III. Past reforms of the fiscal framework (SGP milestones and objectives)
- Major reform milestones:
  - 2005 revision: more flexibility and emphasis on structural balance concepts.
  - 2011 “Six-Pack”: five regulations and one directive; earlier and stronger sanctions; introduced 1/20th debt reduction benchmark as possible EDP trigger.
  - 2013 “Two Pack”: reinforced budgetary surveillance and coordination for euro area countries.
  - Treaty on Stability, Coordination and Governance (TSCG)/Fiscal Compact (FC): 25 member states committed to transpose elements of SGP into national legislations.
- Five primary reform objectives:
  - Stronger economic underpinnings: shift toward structural balance and expenditure benchmark.
  - Better alignment of fiscal targets with final debt objective: focus on public debt, debt reduction benchmark.
  - Strengthened enforcement mechanisms: transposition to national law, independent institutions (fiscal councils).
  - More flexibility: extended escape clauses for structural reforms and exceptional events.
  - Greater specificity: country-specific MTOs, quantified annual fiscal effort, differentiated rules.

### IV. Track record under the SGP and compliance
- Long-run facts:
  - Public debt-to-GDP ratio increased from below 60 percent in 1991 to over 70 percent in the late-1990s.
  - Debt-to-GDP rose from 57 percent in 1991 to 74 percent in 1996 (17 percentage point increase in five years).
  - During 2004–07 average structural balance: deficit of 2.6 percent of GDP.
  - EA18 primary deficit-to-GDP ratio rose by about 7.7 percentage points during 2008–13.
  - Public debt-to-GDP ratio reached 95 percent in 2013.
- Compliance and preventive arm performance:
  - Noncompliance frequent; as of 2014 most euro area economies breached at least one fiscal rule.
  - About half of countries missed the 60 percent debt ceiling more than half of the time; EA aggregate above 60 percent every year since 1999.
  - Structural deficits persistent; compliance with “close to balance position” extremely rare.
  - In the EA-18 as a whole, there has not been a single year with a structural deficit below 1 percent of potential GDP.
  - Over 1999–2013 the euro area tended to tighten (resp. loosen) the structural stance by about 1 percentage point following a year with a negative (resp. positive) output gap — indicating procyclical bias overall.
- Assessment:
  - Successive reforms introduced improvements (measurement, earlier sanctions, specificity) but failed to prevent steady deterioration and pervasive noncompliance.

### Appendix findings: procyclicality, simulations, and measurement error
- Procyclicality of fiscal policy:
  - Panel econometric analysis confirms marked procyclicality during upturns since 1999; fiscal policy mildly countercyclical in downturns.
  - Instrumental-variable estimates confirm strong procyclical bias during upturns under EMU.
- Simulation (EA-18 aggregate) of a simple countercyclical rule (1999–2008):
  - Structural position changes by 0.5 percent of GDP: improves by 0.5 percent when previous year’s output gap positive; decreases by 0.5 percent when previous year’s output gap negative.
  - Structural stance unchanged when output gap between -1 and 1 percent.
  - Fiscal multiplier of 1 declining to 0 in five years used to estimate GDP effects.
  - Main finding: euro area would have entered the crisis with a neutral (balanced) structural position and with a debt ratio slightly under 60 percent of GDP—about 10 percentage points below the actual 2008 level.
- Output gap measurement error and structural balance:
  - Real-time output gaps underestimated on average by about 1 percent compared to ex post data, implying structural balance initially overestimated by 0.5 percent of potential output (assuming budget semi-elasticity of 0.5).
  - Consequence: real-time structural balance rules would tend to allow deficits about 0.5 percentage point per year larger than ex-post targets, producing permanent drift without correction.

### Quantitative econometric results (selected coefficients)
- Table A.6 (∆CAPB; Panel fixed effect):
  - Debt/GDP (t-1): 1981–2013 = 0.029*** (0.008); 1999–2013 = 0.055*** (0.014).
  - Output gap(t-1)*ind(gap>0): 1999–2013 = -0.186** (0.091).
  - Output gap(t-1)*ind(gap<0): 1999–2013 = 0.165* (0.098).
- Table A.7 (CAPB; Kiviet dynamic estimator):
  - CAPB (t-1): 1999–2013 = 0.753*** (0.075).
  - Debt/GDP (t-1): 1981–2013 = 0.021** (0.011).
  - Output gap(t-1)*ind(gap>0): 1999–2013 = -0.217** (0.103).
  - Output gap(t-1)*ind(gap<0): 1999–2013 = 0.192** (0.115).
- Table A.8 (∆CAPB; IV estimator):
  - Debt/GDP (t-1): 1999–2013 = 0.058*** 0.066*** (0.014) (two reported columns).
  - Exp. output gap (t)*ind(Exp. gap>0): 1999–2013 = -0.294** (0.144).
  - Exp. gap (t)*ind(Exp. gap<0): 1999–2013 = 0.251** (0.130).
- Note: *,**,*** indicate significance at 10%, 5%, and 1% respectively.

### Measurement issues and rule complexity
- Migration from nominal to structural targets: rationale and shortcomings
  - Shortcomings of 3 percent nominal deficit ceiling:
    - Compatible with large structural deficits in booms (example: current output 4 percent above potential implies 3 percent nominal deficit = 5 percent structural deficit).
    - Under low nominal growth (about 3 percent), a 3 percent nominal deficit suggests debt convergence toward 100 percent of GDP rather than 60 percent.
    - Ceiling identical for all countries; creates incentives for one-offs and does not capture stock-flow adjustments.
  - Advantages of structural balance and MTO:
    - Decomposes fiscal position into cyclical/transitory vs. policy stance.
    - More directly under government control; supports medium-term perspective and allows automatic stabilizers.
    - MTO is country-specific and accounts for debt levels and ageing costs.
  - Practical difficulties with structural indicators:
    - Prone to ex-post revisions due to potential GDP measurement bias.
    - Real-time underestimate of output gap (~1 percent) implies structural balance overestimate (~0.5 percent of potential output).
    - Difficulty extracting non-discretionary revenue component; standard constant-elasticity methods may miss asset/commodity cycles and compositional changes.

- Growing complexity of the SGP:
  - Supranational constraints as of 2014 include:
    - Convergence towards 60 percent of GDP debt target at a sufficient pace.
    - Prohibition of breaching 3 percent nominal GDP deficit threshold.
    - Mandated improvement of structural balance by average rate of 0.5 percent per year until reaching MTO.
    - Government spending (net of new revenue measures) constrained to grow in line with trend GDP (expenditure benchmark).
    - Under EDP, specific nominal and structural balance targets apply.
    - Fiscal Compact requires national rules for convergence toward MTOs.
  - Risks from overlap and inconsistency:
    - Revisions to medium-term growth estimates weaken deficit-debt link.
    - MTO typically more binding than the 3 percent rule; MTO implies fiscal balance above debt-stabilizing level.
    - Inconsistencies between national and supranational rules complicate conduct and transparency (example: Germany’s 0.35 percent constitutional federal structural deficit vs. general government MTO of 0.5 percent).

### Box 1: Bottom-up approach to estimating discretionary revenues (methodology and implications)
- Method:
  - Uses budget estimates of tax measures to proxy discretionary revenue shocks.
- Practical difficulties:
  - Benchmark of “unchanged policy” ambiguous.
  - Quantification methodologies may be non-transparent or incorrect; may differ across countries.
  - Yields may be based on wrong macro assumptions; administrative measures hard to assess.
  - Suspended or reversed measures create recording difficulties.
- Implications for MTOs and debt dynamics:
  - MTOs often imply steep debt declines; steady-state debt associated with MTO (-0.5 percent of potential GDP) around 20–30 percent of GDP.
  - MTOs updated every three years; lower bound: MTOs cannot fall below structural deficit of 1 percent of potential GDP.
  - Example calculations cited:
    - A deficit of 0.5 percent with nominal growth 3 percent would bring debt towards 17 percent of GDP (deficit*(1+g/g) = 0.5*1.03/0.03).
    - A 1 percent deficit implies debt towards 34 percent of GDP.
- Measurement accuracy:
  - Structural indicators preferred over nominal balance; using nominal balance increases error by about 25 percent compared with real-time structural balance.
  - Empirical country average indicators (Table 2 — Simple Average): Structural Balance average error = 1.24; maximum error = 2.67; average error 4 = 1.01.
  - Selected country examples (Structural Balance — Period / Average error 2 / Maximum error 3 / Average error 4):
    - Austria 2003-2013 0.64 1.45 0.35
    - Belgium 2003-2013 0.64 1.31 0.62
    - Estonia 2004-2013 2.84 6.20 2.54
    - Spain 2005-2013 2.18 3.67 0.83
    - Simple Average 1.24 2.67 1.01

### Box 2: Trade-offs between fiscal consolidation and structural reforms; investment and EFSI
- Evidence and recommendations:
  - Structural reforms can lift medium/long-term growth but often implemented in countries with healthy fiscal positions or with demand-supporting policies.
  - Structural reforms may have large short-term budgetary costs (direct and indirect).
  - Recommendation: complement reforms with policies to boost aggregate demand.
- Public investment concerns:
  - MTO and 3 percent cap may discourage public investment; investment deceleration pronounced in crisis-hit countries (Greece, Ireland, Portugal).
  - “Golden rule” (excluding capital outlays) has drawbacks: weakens link to gross debt, may reduce transparency, risk of creative accounting.
- Pan-European funding and EFSI:
  - EFSI aims to use €21 billion of existing public funds as a guarantee to stimulate private investment totaling €315 billion over three years (2.3 percent of EU GDP).
  - Emphasizes private or public-private partnerships rather than traditional government-financed infrastructure.
- Coordination of fiscal councils:
  - No formal structure for coordination between fiscal councils and the European Commission; EUNIFI created in 2013.
  - Risks from lack of coordination include conflicting messages and undermined credibility.
- Enforcement limitations and recent reforms:
  - Peer pressure weak when many delinquents; sanctions rarely applied.
  - Fiscal Compact transposes structural balance rules into national law; reverse qualified majority makes it harder for the Council to counter Commission recommendations.
  - Concerns remain about evenhandedness and political constraints.

### Box 3: Fiscal constraints on sub-central governments in federations and implications
- Three forms of constraints (by degree of subnational autonomy):
  - Direct administrative controls (lowest autonomy).
  - Fiscal rules (most common; about 90 percent of constraints in 13 federations).
  - Cooperative approaches (highest autonomy).
- SGP comparative notes:
  - Corrective arm broadly fits standard model; preventive arm is EU-specific with surveillance and coordination.
  - Reforms have blurred preventive/corrective distinction; redundancy and conflicting targets have emerged.
- Operational target design:
  - Favor a fiscal anchor (debt ratio) and an operational target under government control.
  - “Fiscal effort” (first-difference rule) highlighted as natural operational target:
    - Measures: bottom-up aggregation of budget measures; top-down ∆ structural fiscal balance; expenditure growth ceiling relative to potential output.
  - Expenditure growth ceiling is tractable and communicable if linked to long-term output growth; evidence supports its effectiveness when coupled with debt feedback and correction mechanisms.

### Box 4: How to move forward with the structural balance indicator
- Methodological improvements:
  - Multivariate filters using capacity utilization reduce end-point problem and lowered spread between real-time and mature output gap estimates by around 20 percent on average.
  - Expenditure benchmark uses 10-year average including 5 years of outturn, current year, and 4 years of forecasts to smooth volatility.
- Accounting for bias and notional correction mechanisms:
  - Options include ex-ante ad hoc adjustment factors or a notional account (Swiss debt-brake model) recording ex-post deviations with correction requirements if thresholds exceeded.
- Alternatives:
  - Replace structural balance with indicators that mimic its properties without output-gap reliance (e.g., “augmented growth-based balance rule”).
  - Abandon structural balance for an expenditure rule with debt-linked correction mechanism.
  - Maintain simple rules (e.g., 3 percent) for transparency but recognize weak economic rationale.
- Coordination improvements:
  - Institutionalize two-way exchanges between national fiscal councils and the Commission (EUNIFI, multilateral meetings).
  - More ambitious: EU-wide council reporting to European Parliament — limited interest currently.
- Strengthening enforcement:
  - Increase automaticity of procedures and acceleration of steps after breaches; retain discretionary judgment for sanctions.
  - Institutional options: give Commission stronger sanction authority with Council veto; require Council to publicly justify deviations.
  - Broaden sanctions (financial in good times; non-pecuniary in bad times).
- Debt-brake considerations:
  - Debt brakes record deviations in a notional account and require correction when thresholds exceeded.
  - Criticisms: may force unrealistic overshooting; never offsetting past deviations also misguided.
  - Balanced approach: gradual correction for countries with debt below 60 percent via calibrated fiscal rules.
- Market discipline vs central controls:
  - Market discipline weakened by bailout credibility and sovereign-bank links; restoring it requires clear private creditor involvement rules and gradual transition.
  - Central controls (veto power on budgets) would reduce fiscal sovereignty and require deeper analysis.

### Reform design feature emphasized in the paper
- Adjustment path headline: 0.5 percent of GDP per year in structural terms toward MTO.
- Features:
  - Progress towards MTO assessed with an expenditure benchmark.
  - Escape clauses: none in basic specification; deviations allowed for structural reforms with short-term costs and for unusual events/general crisis.
  - Monitoring: European Commission, European Council, European Semester, assessment of draft budgets in the Fall, monitoring by fiscal councils.
  - Enforcement: EDP recommendations as corrective mechanism; financial sanctions available at late stages and reformed voting procedures for euro-area countries.
  - For corrective arm: annual adjustment of at least 0.5% of GDP in structural terms; “adjusted fiscal effort” indicator introduced.
  - For pluriannual EDP: intermediate objectives binding; possible deadline extensions if fiscal effort is delivered or in case of general crisis.

### Selected euro area aggregate series (tables referenced)
- Euro Area (18) General Government Overall Balance, 1999–2013 (Percent of GDP): -1.5 -0.1 -2.0 -2.7 -3.2 -2.9 -2.5 -1.4 -0.7 -2.1 -6.3 -6.2 -4.1 -3.7 -3.0
- Euro Area (18) General Government Debt, 1999–2013 (Percent of GDP): 71.6 69.2 68.2 68.0 69.2 69.6 70.5 68.6 66.2 70.1 79.9 85.7 88.1 92.7 95.0
- Euro Area (18) General Government Structural Balance, 1999–2013 (Percent of potential GDP): -1.8 -1.1 -3.0 -3.2 -3.4 -3.1 -2.8 -2.3 -2.2 -3.0 -4.5 -4.4 -3.5 -2.1 -1.3

*Source: Extracted from _wp1567 (IMF working paper): "1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013".*

### 1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013 ................8

### 1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013 ................8

### Chapter components
- Title: "1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013"
- Page index: 8

### Subsections and related sections listed in the source
- 2. Measurement Error of the Structural Stance ........................................................................22
- A.1. Reforms of the Preventive Arm of the SGP .....................................................................38
- A.2. Reforms of the Corrective Arm of the SGP .....................................................................39
- A.3. Euro Area: General Government Overall Balance, 1999–2013 ......................................40
- A.4. Euro Area: General Government Debt, 1999–2013 .........................................................41
- A.5. Euro Area: General Government Structural Balance, 1999–2013 ...................................42
- A.6. Cyclical Sensitivity of the Structural Fiscal Effort ..........................................................45
- A.7. Cyclical Sensitivity of the Structural Fiscal Balance .......................................................46
- A.8. Cyclical Sensitivity of the Structural Fiscal Effort, IV Estimation..................................46

### Figures referenced in the chapter
- 1. Public Debt Ratio ...................................................................................................................6
- 2. Main Objectives of Past Fiscal Governance Reforms .........................................................11
- 3. Non-compliance with European Fiscal Rules ......................................................................12
- 4. Structural Balance and Output Gap .....................................................................................13
- 5. Public Debt...........................................................................................................................14
- 6. Supranational Constraints and Rules on Fiscal Aggregates ................................................15
- 7. Number of Federations with Central Constraints on Subnational Entities ..........................16
- 8. Simulated Debt Reduction in 2019 ......................................................................................17
- 9. Real-Time Estimation Error of the Output Gap ...................................................................19
- 10. Investment in the Euro Area ..............................................................................................24
- 11. Euro Area: Share of Non-Compliers..................................................................................27

### Boxes included
- 1. The Bottom-Up Approach To Estimating Discretionary Revenues ....................................20
- 2. Is There a Trade-Off Between Fiscal Consolidation and Structural Reforms? ...................24
- 3. How Do Federations Constrain the Fiscal Policy of Sub-central Governments? ................29
- 4. How To Move Forward with the Structural Balance Indicator?..........................................33

### Appendices
- 1. Debt Decomposition Methodology ......................................................................................43
- 2. Procylicality of Fiscal Policy in the Euro Area ...................................................................44

*Source: _wp1567 - 1. Decomposition of Debt Changes in the Euro Area Between end-2007-end-2013 ................8*

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

### _wp1567 - References

### I. Introduction
- The Stability and Growth Pact (SGP) is central to European fiscal governance; its origin dates to the 1992 Maastricht Treaty and EMU.
- Rationale for fiscal rules: prevent national fiscal policies from producing negative spillovers (unwanted monetary tightening, higher area-wide interest rates due to crowding out, contagion effects, bailout costs) given a common monetary policy and decentralized fiscal policies (EC, 2013a).
- Euro area crisis exposed gaps in fiscal governance and monetary union functioning: failure to prevent a surge in public debt (partly from national public support to impaired financial sectors); rules did not always foresee exceptional economic circumstances (IMF, 2013b); sovereigns could be priced out of markets and contagion produced deep recessions and fiscal stress.
- Weak fiscal governance predates the crisis: insufficient fiscal buffers in good times, windfalls from lower interest and debt payments were not saved, higher revenues from unsustainable demand booms treated as permanent (Allard and others, 2013); uneven enforcement (European Council put SGP procedures in abeyance in 2003).
- Objectives of the paper: take stock of recent reforms, identify areas for further progress, discuss policy options; structure outlined (Sections II–VII).

### II. The Setting: Public Debt on an Upward Trend
- Long-term trend and key facts:
  - Public debt-to-GDP ratio increased from an average level of below 60 percent of GDP in 1991 to over 70 percent of GDP in the late-1990s.
  - Debt-to-GDP rose from 57 percent in 1991 to 74 percent in 1996—a 17 percentage point increase in five years.
  - During 2004–07, the average structural balance stood at a substantial deficit of 2.6 percent of GDP.
  - During 2004–07 the debt-to-GDP ratio edged down by only 3 percentage points despite strong economic performance.
  - In the EA18 as a whole, the primary deficit-to-GDP ratio rose by about 7.7 percentage points during 2008–13.
  - The public debt-to-GDP ratio soared to 95 percent in 2013, almost 30 percentage points above the pre-crisis level.
- Asymmetric debt dynamics:
  - Debt rose quickly during downturns but only declined mildly during expansions.
  - Governments frequently failed to save revenue windfalls; expenditure slippages often exceeded planned pace, especially when revenues were unexpectedly high.
  - When revenue shortfalls occurred, expenditures were adjusted down in only a quarter of cases.
- Crisis drivers and decomposition (EA18 aggregate, end-2007 to end-2013):
  - Total increase in debt/GDP ratio: 28.8 percentage points (pps).
  - Stock-flow adjustment: 9.4 pps (33% of total increase) — largely financial sector intervention, rescue packages, realization of contingent liabilities.
    - Example: Ireland banking sector rescue led to an unexpected increase in the debt-to-GDP ratio by 25 percentage points.
    - Bank support costs in some cases amounted to about 40 percent of GDP, with partial financing through financial asset sales.
  - Overall deficit contribution: 19.4 pps (67%).
    - Interest rate-growth differential: 11.6 pps (40%).
      - Nominal GDP growth contribution: -5.0 pps (-17%).
      - Interest rate (cumulative interest payments): 16.6 pps (58%).
    - Primary deficit: 7.8 pps (27%).
      - Cyclical component: 5.3 pps (18%).
      - CAPB (cyclically adjusted primary balance): 2.5 pps (9%).
        - One-offs: 1.3 pps (5%).
        - Structural balance: 1.1 pps (4%).
- Key lessons:
  - A substantial portion of the debt increase reflected automatic stabilizers and exogenous factors (bank bailouts, interest bill), not discretionary fiscal stimulus.
  - Countries entered the crisis with insufficient fiscal buffers; the 3 percent of GDP nominal deficit ceiling did not prevent spending of revenue windfalls in mid-2000s.
  - Recommendation implied: build sufficient fiscal buffers in good times to accommodate shocks.

### III. Past Reforms of the Fiscal Framework
- Legal and institutional basis:
  - Framework established by the Treaty on European Union and the Treaty on the Functioning of the European Union; SGP is implemented through secondary legislation.
  - SGP has preventive and corrective arms: preventive to ensure sustainability and avoid excessive deficits; corrective to impose sanctions and corrective actions when excessive deficits arise from “gross policy mistakes.”
- Major reform milestones:
  - 2005 revision: introduced more flexibility and improved economic underpinnings; elevated structural balance concepts.
  - 2011 “Six-Pack”: five regulations and one directive; new rules, earlier and stronger sanctions, additional escape clauses; introduced 1/20th debt reduction benchmark as possible EDP trigger.
  - 2013 “Two Pack”: reinforced budgetary surveillance and coordination for euro area countries.
  - Treaty on Stability, Coordination and Governance (TSCG)/Fiscal Compact (FC): 25 member states committed to transpose elements of SGP into national legislations.
- Five primary objectives pursued by successive reforms:
  - Stronger economic underpinnings: shift from nominal towards “conditional” compliance, structural balance and expenditure benchmark, “adjusted fiscal effort.”
  - Better alignment of fiscal targets with final debt objective: focus on public debt, introduction of debt reduction benchmark.
  - Strengthened enforcement mechanisms: transposition to national level, earlier and stronger sanctions, involvement of independent institutions (fiscal councils).
  - More flexibility: extended escape clauses, allowed deviations for structural reforms with short-term costs and long-term gains.
  - Greater specificity: country-specific MTOs, quantification of annual fiscal effort, differentiated rules across member states.

### IV. Track Record under the SGP
- Compliance overview:
  - Noncompliance has been frequent; as of 2014 most euro area economies breached at least one fiscal rule.
  - Compliance highest with the 3 percent deficit ceiling in the pre-crisis period: on average, the deficit of the euro area was slightly below 2 percent of GDP during 1999-2007.
  - About half of countries have missed the 60 percent debt ceiling more than half of the time; at the euro area aggregate (EA12 or EA18) public debt has been above 60 percent of GDP every year since 1999.
- Structural positions and preventive arm performance:
  - Structural deficits have been persistent; compliance with the “close to balance position” has been extremely rare (exceptions: Finland and Luxemburg).
  - In the euro area-18 as a whole, there has not been a single year with a structural deficit below 1 percent of potential GDP.
  - Over 1999–2013, the euro area tended to tighten (resp. loosen) the structural stance by about 1 percentage point following a year with a negative (resp. positive) output gap, indicating a pro-cyclical fiscal response overall.
  - The preventive arm failed to foster sufficient buffer buildup in good times; despite a positive or near-zero output gap from 1999 to 2008, the structural balance averaged a deficit of 2.5 percent in the euro area.
- Overall assessment:
  - Successive reforms introduced positive elements (better measurement, earlier sanctions, greater specificity), but they were not sufficient to prevent steady deterioration in public accounts and pervasive noncompliance with rules.

*Source: _wp1567 - References*

### Appendix 2

### _wp1567 - Appendix 2

### Procyclicality of Fiscal Policy and Quantitative Findings
- Panel econometric analysis confirms marked procyclicality during upturns since 1999, while fiscal policy has been mildly countercyclical in downturns.
- Figure 4 analysis uses the previous year’s output gap to minimize feedback from fiscal stance to output gap; note: the 2009 data point relates the 2008 output gap to the change in the structural balance in 2009 relative to 2008.
- Simulation (EA-18 aggregate) assuming a simple countercyclical rule from 1999 to 2008:
  - Structural position changes by 0.5 percent of GDP: improves by 0.5 percent when previous year’s output gap is positive; decreases by 0.5 percent when previous year’s output gap is negative.
  - Assumes structural stance unchanged when output gap is between -1 and 1 percent.
  - Uses a fiscal multiplier of 1 declining to 0 in five years to estimate GDP effects of the implicit fiscal shock.
  - Main finding: the euro area would have entered the crisis with a neutral (balanced) structural position and with a debt ratio slightly under 60 percent of GDP—about 10 percentage points below the actual 2008 level.
  - Real-time output gap data would not fundamentally change this result; downward bias concerns level rather than first difference.

### Growing Complexity of the Stability and Growth Pact (SGP)
- History and drivers of complexity:
  - Initial Pact included three supranational rules, of which only one was truly binding.
  - Subsequent fiscal crisis and perceived shortcomings prompted additional rules (e.g., structural balance supplementing nominal deficit ceiling).
  - Complexity increased to ensure enforcement across circumstances (structural balance rule, expenditure benchmark) and due to relative paucity of national rules initially.
  - Political factors and mutual lack of confidence led to over-specification of rules and procedures.
- As of 2014, supranational constraints tie fiscal aggregates in an intricate set of constraints:
  - Converge towards 60 percent of GDP debt target at a sufficient pace.
  - Prohibited from breaching the 3 percent of nominal GDP deficit threshold.
  - Mandated to improve the structural balance to GDP ratio at an average rate of 0.5 percent per year until reaching MTO.
  - Government spending (net of new revenue measures) constrained to grow in line with trend GDP.
  - Under EDP, subject to specific nominal and structural balance targets.
  - Fiscal Compact (25 member states) requires convergence toward MTOs by means of a national rule whose specification may differ from the MTO’s.

### Communication, Overlap, and Inconsistency Risks
- Sophisticated rules increase flexibility but are more difficult to communicate and explain to the public.
  - The simple 3 percent deficit target has prominence; newer structural indicators (expenditure benchmark) and escape clauses reduce transparency.
  - Independent fiscal institutions can estimate and explain structural balances and deviations to offset complexity costs.
- High number of rules and sub-rules creates risks of overlap and inconsistency:
  - EU imposes more constraints on subnational governments (about five constraints in the euro area vs. two on average in 13 federations).
  - Many European rules restrict both the level and first difference of fiscal targets, with staged implementation and progressive corrective actions.
- Specific policy risks:
  - Revisions to medium-term growth have weakened the link between deficit and debt ceilings: the 3 percent nominal deficit rule, under downward revisions to potential growth (currently estimated about 3 percent nominal in many euro area countries), suggests debt would converge towards 100 percent of GDP (versus 60 percent under earlier 5 percent growth assumption).
  - Overlap and potential redundancy between structural and nominal targets:
    - MTO (structural balance target) is generally more binding than the 3 percent nominal deficit rule; output gap rarely deteriorates beyond 5 percent.
    - MTO typically brings fiscal balance above the debt-stabilizing level, resulting in steady debt ratio reduction.
    - Simulations (based on WEO forecasts covering 2014–19) assume countries improve structural deficits by 0.5 percent of potential GDP annually until reaching MTO; fiscal multiplier of 0.5 declining steadily to 0 in 5 years is used to simulate GDP relative to WEO forecasts. Simulation results are very sensitive to assumptions.
  - Inconsistency between national and supranational rules:
    - Fiscal Compact transposition into national law can create differing targets and procedures (e.g., Germany’s constitutional federal structural deficit threshold of 0.35 percent of GDP from 2016 and state structural balance from 2020 differs from the general government MTO of 0.5 percent structural deficit ceiling).
    - Differences complicate conduct and transparency when a target is met supranationally but not nationally (or vice versa).

### Migration from Nominal to Structural Balance Targets: Rationale and Shortcomings
- Shortcomings of the 3 percent nominal deficit ceiling:
  - Compatible with very large structural deficits in booms (example: current output 4 percent above potential implies a 3 percent nominal deficit translates into a 5 percent structural deficit).
  - Does not prevent structural medium-term drift of public finances (3 percent under 3 percent nominal growth would bring public debt towards 100 percent of GDP).
  - Ceiling identical for all countries, unrelated to debt level and growth potential; creates incentives for one-off measures and does not capture stock-flow adjustments (stock-flow adjustments accounted for about one third of the euro area debt increase during the recent crisis).
- Advantages of the structural balance and MTO:
  - Structural balance decomposes fiscal position into response to economic activity and transitory factors vs. policy stance.
  - Structural balance is more directly under government control and changes map to discretionary fiscal measures.
  - Encourages medium-term perspective and allows automatic stabilizers to operate.
  - MTO is country-specific and accounts for debt levels and ageing costs; MTO reference value designed to ensure course toward sustainable debt position.
- Practical difficulties and shortcomings of structural indicators:
  - Structural balances are prone to ex-post revisions due to measurement bias of potential GDP.
  - Real-time output gaps are underestimated on average by about 1 percent compared to ex post data, implying structural balance initially overestimated by 0.5 percent of potential output (assuming budget semi-elasticity of 0.5).
    - Consequence: real-time structural balance rules would tend to allow excessively large deficits exceeding ex-post targeted values by about 0.5 percentage point per year, producing a permanent drift of public finances without correction.
  - Difficulty extracting non-discretionary revenue component:
    - Standard methodology uses constant elasticities of revenue to the output gap but may not remove all cyclical factors (asset/commodity price cycles, compositional changes).
    - Two approaches to improve measurement:
      - Adjust structural balance formula beyond output gap (new indicators correct for broader macroeconomic fluctuations; adds complexity).
      - Expenditure benchmark approach measuring discretionary revenues via a “bottom-up” method using budget estimates of tax measures mandated by law—conceptually appealing but with practical estimation difficulties.

*Source: _wp1567 - Appendix 2*

### Box 1. The Bottom-Up Approach to Estimating Discretionary Revenues

### Box 1. The Bottom-Up Approach to Estimating Discretionary Revenues

### Methodology and practical difficulties
- The bottom-up approach uses budget estimates of tax measures to proxy discretionary revenue shocks.
- Key practical difficulties:
  - Fiscal measures are assessed against a benchmark of “unchanged policy,” which is not always clearly defined; a no-policy change scenario is open to interpretation.
  - The methodology used to quantify the effect of measures may not be transparent or even be incorrect. Methodology may differ across countries and be influenced by data availability and political decisions. This is particularly problematic when the EC takes revenue estimates from national authorities at face value.
  - Quantification may be based on wrong macro assumptions; the yield of administrative measures is particularly difficult to assess.
  - Conflicting evidence from various official sources may necessitate building a “consensus estimate” of the size of fiscal shocks.
  - Suspended measures create recording difficulties: if measures are announced for the future and then reversed, two or zero measures can be registered depending on whether the initial measure is included in the baseline.

- Additional context and notes:
  - To promote budgetary transparency, some governments now provide “policy costings” of tax (and spending) measures in the budget with accompanying documentation (example cited: United Kingdom).
  - The expenditure benchmark is conceptually equivalent to the change in the structural balance; the revenue part of the expenditure benchmark relies on bottom-up estimates.

### Implications for debt dynamics and MTOs
- Observations:
  - In most countries, the MTO implies a very steep decline in debt ratios, raising feasibility and political acceptability concerns.
  - The steady state debt associated with a medium-term position at the MTO (-0.5 percent of potential GDP) is around 20–30 percent of GDP.
  - The SGP partially recognizes the issue through the formula used to derive the MTO (which takes into account the debt level) and a provision that MTOs can be lower when debt is low and there is no long-run sustainability issue.
  - MTOs are updated every three years, allowing adjustments if the target is not appropriate. However, there is a lower bound: MTOs cannot fall below a structural deficit of 1 percent of potential GDP.
  - The 1 percent lower bound still implies very low steady-state debt ratios; the calculation example indicates:
    - In the steady state (with an output gap equal to zero), a deficit of 0.5 percent of GDP would bring the debt ratio towards 17 percent of GDP (deficit*(1+g/g) = 0.5*1.03/0.03) if nominal growth equals 3 percent a year.
    - According to the formula, the MTO level is readjusted when debt declines, but it cannot go beyond a 1 percent deficit, which would bring debt towards 34 percent of GDP.

### Measurement accuracy: structural balance versus nominal balance
- Key points:
  - Emphasis on structural indicators remains appropriate: structural balance imperfectly filters out asset and commodity price cycles but is still more “accurate” than the nominal balance, which does not extract these factors.
  - The output gap measurement error is usually lower than the “noise” created by the cyclical component of the nominal balance.
  - Using the nominal balance to measure the underlying fiscal position increases error by about 25 percent compared with the real-time structural balance (whether or not Estonia and Latvia are included in the sample).
  - Discrepancies are larger at the peaks/troughs of the cycle.
  - Output gap measurement error is less of an issue when structural indicators are expressed in first-difference.

- Definitions and formulas (as presented):
  - If OB is the nominal balance; OCF denotes other cyclical and temporary factors; the “true” (ex post) cyclically-adjusted balance is denoted by a variable; CAB is the “incorrect” cyclically-adjusted balance based on real-time output gap data; the real-time (resp. ex post) output gap denoted accordingly. The text outlines algebra showing structural balance is more accurate than OB under the condition that the output gap level is larger than its measurement error. These formulas are used in Table 2.

### Empirical measurement error (Table 2 highlights)
- Source: IMF Staff estimates using real-time data from stability and convergence programs, and ex-post data from the AMECO database.
- Table 2 indicators and notes:
  - 1/ Depends on the availability of stability and convergence programs.
  - 2/ Average absolute value of the cyclical component of the nominal balance (measured as the product of the budget semi-elasticity and the ex post output gap).
  - 3/ Maximum absolute value of the cyclical component (corresponding to the maximum absolute output gap over the period times the budget semi-elasticity).
  - 4/ Average of the absolute differences between ex-post and real-time output gaps times the semi-budget elasticity.

- Selected country figures from Table 2 (Structural Balance — Period / Average error 2 / Maximum error 3 / Average error 4):
  - Austria 2003-2013 0.64 1.45 0.35
  - Belgium 2003-2013 0.64 1.31 0.62
  - Cyprus 2004-2013 0.75 1.88 1.21
  - Estonia 2004-2013 2.84 6.20 2.54
  - Finland 2003-2013 1.12 2.70 1.02
  - France 2004-2013 1.09 1.71 1.18
  - Germany 2006-2013 0.69 2.10 0.45
  - Greece 2003-2010 0.86 2.33 0.65
  - Ireland 2003-2013 0.98 2.25 1.15
  - Italy 2003-2013 1.11 1.75 0.94
  - Latvia 2004-2013 3.25 6.00 2.08
  - Luxembourg 2003-2013 1.11 2.52 0.81
  - Malta 2004-2013 0.50 1.51 0.78
  - Netherlands 2005-2013 0.92 1.24 0.48
  - Portugal 2003-2013 0.95 2.51 0.86
  - Slovak Republic 2004-2013 1.41 3.94 1.30
  - Slovenia 2004-2013 1.37 2.93 1.01
  - Spain 2005-2013 2.18 3.67 0.83
  - Simple Average 1.24 2.67 1.01

### Reconciling fiscal sustainability and growth objectives under the SGP
- Background and trade-offs:
  - The SGP aims to foster growth while preserving fiscal discipline within the EMU, balancing stabilization needs (automatic stabilizers and discretionary policy) and the prevention of free riding on the single currency.
  - The euro area's growth performance since the 1990s has been lackluster, with an average annual GDP growth rate 1 percentage point below that of the United States; some argue the SGP tilts toward sustainability at the expense of growth.

- Stabilization space:
  - With a budget semi-elasticity of 0.5 and a structural deficit of 0.5 percent, a deficit ceiling of 3 percent is compatible with full operation of automatic stabilizers in downturns up to a negative output gap of 5 percent.
  - The SGP does not compel countries to offset cyclical variations in spending and revenue unless the crisis is exceptionally severe, in which case the escape clause would probably be triggered.
  - The lower limit of the MTO (-0.5 percent as a general rule, and -1.0 percent in low-debt countries) leaves little room for fiscal relaxation if the initial position is balanced; the preventive arm includes economic downturn escape clauses authorizing temporary deviations from the MTO or the path towards it.
  - In a “normal” downturn corresponding to an output gap of -2 percent, a 3 percent deficit would correspond to a structural deficit of 2 percent, leaving some room for discretionary actions if the initial position is close to balance.

- Structural reform trade-offs and framework flexibility:
  - Annual/short-term constraints of the SGP may limit fiscal space for introducing structural reforms that foster long-term growth.
  - The 2005 reform of the SGP recognized trade-offs by allowing temporary deviations from the MTO in the preventive arm and flexibility in the EDP for countries introducing some reforms; in practice, this framework mainly applies to pension reforms.
  - Empirical literature provides mixed evidence on the budgetary impact of structural reforms: broad reforms do not show significant effects on the cyclically-adjusted deficit in some studies, but some specific reforms (e.g., active labor market policies) can have large short-term costs (OECD estimates exceed 1 per cent of GDP in some countries).
  - Recommendations:
    - Further research should focus on the budgetary impacts of particular structural measures.
    - Any flexibility in the framework should be tied to the implementation (beyond announcements) of reforms, though monitoring implementation may prove difficult.

*Source: IMF staff box text (Box 1. The Bottom-Up Approach to Estimating Discretionary Revenues).*

### Box 2. Is There a Trade-Off Between Fiscal Consolidation and Structural Reforms?

### Box 2. Is There a Trade-Off Between Fiscal Consolidation and Structural Reforms?

### Evidence on structural reforms and fiscal positions
- Structural reforms can lift growth in the medium to long-term.
- Structural reforms are often successfully implemented in countries with healthy initial fiscal positions or countries that adopt policies supporting aggregate demand (IMF 2004; Beetsma and Debrun, 2004; Høj and others, 2006).
- Recommendation: Structural reforms should be complemented by policies to boost aggregate demand (Barkbu and others, 2012).

### Reasons fiscal adjustment is often gradual during major structural reform programs
- Political capital may be limited and governments that are too ambitious are unlikely to be reelected.
- Some structural reforms have large short-term budgetary costs:
  - Direct costs (for example, funding a public research and development program).
  - Indirect costs (in particular the cost of compensating the losers).
- Structural reforms may not yield maximum benefits when the economy is weak:
  - Example: when demand is depressed, relaxing employment protection may not stimulate job creation.
  - Example: increasing the retirement age may just raise the number of unemployed.

### Public investment, the MTO/3 percent cap, and the "golden rule"
- Concern: the MTO and, to a lesser extent, the 3 percent deficit cap may discourage public investment, contributing to a long-term declining trend in government investment.
- The public investment deceleration was particularly pronounced in countries hit hard by the crisis, such as Greece, Ireland, and Portugal (IMF, 2014).
- Trade-offs and risks of excluding capital outlays from fiscal targets (the "golden rule"):
  - Intuitive appeal: governments should not attribute the full cost of a multi-period project to a single year’s account.
  - Concerns:
    - Weakens the link between fiscal targets and gross debt.
    - Capital expenditure may not necessarily be productive.
    - Other items (health and education) may raise productivity and potential growth even more.
    - Risks: lower transparency, "creative accounting," and weaker links to sustainability (Cangiano and Ter-Minassian, 2003).
- Alternative within SGP: adjust EDP targets and deadlines when fiscal consolidation protects capital expenditure — but this would complicate the framework and raise practical difficulties similar to those previously described.

### Pan-European funding for public infrastructure and EFSI
- Policy option: boost the ability of the center to fund pan-European public infrastructure, especially cross-border projects with network externalities (energy sector).
- Other financing sources to consider: European Investment Bank (EIB) and other forms of common borrowing.
- EC announcement: European Fund for Strategic Investments (EFSI) aims to use €21 billion of existing public funds (in the form of a guarantee) to stimulate private investment totaling €315 billion over three years (2.3 percent of EU GDP).
- EFSI represents a change in the EU’s format of public funding for investment, emphasizing private or public-private partnership projects rather than traditional government-financed public infrastructure investment.

### Coordination between fiscal councils and the European Commission
- Current law: no formal structure for coordination between fiscal councils and the European Commission.
- Existing practices:
  - Commission engages through bilateral contacts and workshops.
  - OECD network of parliamentary budget officials and independent fiscal institutions brings together staff from fiscal councils (does not cover all EU member states).
  - EU Network of Independent Fiscal Institutions (EUNIFI) created in 2013.
- Risks from lack of coordination:
  - Conflicting messages and diverging views could undermine credibility and enforcement of fiscal rules.
  - Three particular instances of risk:
    - Different assessments of the quality of macroeconomic and budgetary forecasts (e.g., methods to calculate structural balances).
    - Divergent views on implementation of correction mechanisms and escape clauses in case of deviation from MTOs.
    - Collisions between normative assessments by fiscal councils and country-specific recommendations adopted by the European Council.

### Enforcement: limits of peer pressure and recent reforms
- Weak enforcement drivers:
  - Rule design problems and governance failures.
  - SGP targets may be too demanding or rigid, especially in a low-growth environment.
  - Complexity creates new loopholes.
  - Incomplete separation of powers: Council has final word; Commission makes recommendations but lacks full power to act.
  - "Sinners judging sinners" incentive problem: finance ministers may be lenient when assessing peers.
- Crisis amplified limits of moral suasion:
  - Peer pressure less effective when the number of fiscal delinquents rises (reputation costs decline; sanctioning becomes harder).
- Relative weakness of EU enforcement compared with federations:
  - Sanctions often consist of opportunity costs from financial deposits; conditions for converting deposits into fines are very strict and never applied.
  - No administrative sanctions or liability of individual officials as in some federations.
  - Sanctions apply only to euro-area member states; non-euro EDP countries are not required to hold a deposit nor liable for fines for insufficient progress.
  - No federal-style borrowing restrictions or direct controls on national budgets.
- Recent reforms strengthening enforcement:
  - Fiscal Compact: requires countries to introduce structural balance rules in national legislation (preferably in the constitution); these rules should be monitored by independent institutions and incorporate correction mechanisms.
  - Sanctions for euro-area countries have become more automatic via the "reverse qualified majority" procedure, making it more difficult for the Council to go against the Commission’s advice.
- Remaining concerns:
  - New procedures may not ensure absolute evenhandedness; perception that some large countries are treated more leniently may persist.
  - EC staff interactions with national authorities create a risk of internalized political constraints.
  - Suggested safeguard: independent and public reviews of EC recommendations and technical work to strengthen legitimacy and impartiality.

### Issues for discussion and policy options (summary)
- Main argument: possible to simplify the system of rules while keeping flexibility against shocks and strengthening enforcement mechanisms.
- Question posed: Should the preventive and corrective arms be consolidated?
- Federations’ typical rule design features to consider:
  - A rule delineates a numerical target for a fiscal variable over a long period.
  - Provisions for non-compliance, including sanctions and/or corrective actions for subcentral governments.
  - Escape clauses for temporary suspensions of provisions for predetermined events.

*Source: Box 2, "Is There a Trade-Off Between Fiscal Consolidation and Structural Reforms?", _wp1567.*

### Box 3. How Do Federations Constrain the Fiscal Policy of Sub-central Governments?

### _wp1567 - Box 3. How Do Federations Constrain the Fiscal Policy of Sub-central Governments?

### Institutional arrangements and types of constraints
- Federations use institutional arrangements to reduce fiscal discretion of individual states with two main objectives: enforcing fiscal discipline and strengthening coordination across levels of government.
- Three main forms of constraints, ranked by degree of subnational “fiscal autonomy”:
  - Direct (administrative) controls: central government sets/revises ceilings on subnational debt or regulates types of borrowing; associated with the lowest degree of fiscal autonomy.
  - Fiscal rules: less binding than direct controls, preserve some policy flexibility and margin for subnational compliance; rules can be either imposed by the center or self-imposed.
  - Cooperative approaches: ensure the highest degree of subnational autonomy; allow regular renegotiation of fiscal targets.

### Prevalence and nature of fiscal rules in federations
- Fiscal rules are the most common institutional constraint in federations.
  - They account for almost 90 percent of the constraints in a sample of 13 federations.
- Rules are primarily imposed on the fiscal balance of sub-central governments.
- Borrowing constraints and debt rules are also widespread, followed by expenditure rules; revenue rules are rare.
- About half of the sub-central rules in federations tend to be self-imposed (examples: provinces in Canada, states in the United States, Australian states, cantons in Switzerland).
- The pattern differs from unitary countries, where most rules are imposed by the center.

### The Stability and Growth Pact (SGP) and the EU context
- The corrective arm of the SGP broadly fits the standard model (numerical targets for deficit and debt; procedures and escape clauses for non-compliance, e.g., EDP).
- The preventive arm is more specific to the EU: surveillance and coordination to prevent fiscal imbalances and ensure sound medium-term positions.
- Reforms have blurred the preventive/corrective distinction:
  - The preventive arm has acquired standard-rule features: a fiscal target (structural deficit below 0.5 percent), a convergence path in case of deviation, escape clauses, and sanctions.
  - The Fiscal Compact’s requirement to transpose the MTO into national law increases the MTO’s role as an annual target rather than solely a medium-term objective.
- Concerns:
  - Redundant and potentially conflicting fiscal targets have emerged.
  - The EDP is triggered by the 3 percent deficit rule, which may have weaker economic rationale than the preventive arm’s structural balance rule (example: a country at the MTO could still be placed under EDP for breaching the 3 percent ceiling).
- Options for consolidating the two arms:
  - Minimal: enhance consistency between the two arms (e.g., align benchmarks for annual fiscal effort).
  - Ambitious (legal difficulties): merge into a two-step procedure based on a common set of rules with a structural balance indicator as overarching target; mild corrective actions for minor slippages and EDP reserved for serious noncompliance.
  - IMF (2010) proposal: tie EDP exit to the fulfillment of the MTO.

### Design principles: fiscal anchor and operational target
- Ultimate objective: preserve debt sustainability; suggests a two-pillar fiscal framework:
  - Fiscal anchor: debt ratio as the anchor to limit cumulative fiscal slippages.
  - Operational target: under direct government control, closely linked to debt dynamics, easy to monitor, and useful to communicate fiscal stance.
- Public debt cannot serve well as an operational target because changes in debt reflect below-the-line operations and valuation effects; using debt as a short-term target may induce undesirable asset sales.

### Options for operational targets and the “fiscal effort” concept
- Available operational-target options: revenue rule, expenditure rule, nominal balance target (possibly excluding investment), structural balance target (level or first difference), or combinations.
- Current European framework includes many operational targets (e.g., the 3 percent deficit; the expenditure benchmark; nominal deficit targets under the EDP; structural balance indicators in levels and changes). Priority should be reducing their number and focusing on the most economically relevant.
- The “fiscal effort” is highlighted as the most natural operational target:
  - Defined as the change in the fiscal stance resulting from discretionary fiscal actions during the year on spending and revenue sides.
  - It is a first-difference rule: directly impacted by discretionary budgetary policy and defines a structural path for future fiscal balances while allowing automatic stabilizers to operate.
- Ways to measure fiscal effort:
  - (i) Bottom-up approach: identify and aggregate budget measures in percent of potential GDP.
  - (ii) Top-down approach: calculate the change in the structural fiscal balance.
  - (iii) Other structural indicators: annual expenditure growth ceiling linked to potential output growth.
- These approaches are theoretically equivalent but often yield different fiscal effort amounts (reasons include differing reference scenarios and timing).

### Expenditure growth ceiling and supporting evidence
- The expenditure growth ceiling is appealing because it is tractable, easy to communicate, and conceptually sound if linked to long-term output growth.
- Empirical and simulation evidence:
  - Debrun and others (2008): an expenditure growth rule with a debt feedback ensures better convergence towards the debt objective while allowing flexibility to shocks.
  - IMF (2012): expenditure growth ceiling performs well on stabilization, transparency, and fiscal discipline when supplemented with a correction mechanism.
  - Carnot (2014): a rule targeting primary expenditure evolution relative to trend output growth (adjusted for discretionary revenue measures) can balance long-term sustainability and short-term stabilization.

### Role and measurement issues of the structural balance (in level)
- Debate on whether to maintain a structural balance target in level alongside the fiscal effort:
  - The debt anchor implicitly determines a steady-state structural balance; setting both may be redundant or inconsistent.
  - The structural balance (in level) is useful to monitor distance to the steady-state and progress towards the debt-consistent level; it relates the operational target (fiscal effort) to the anchor (debt).
  - Example: in the European system, countries must make a fiscal effort of 0.5 percent of GDP per year until they reach their MTO; the structural balance level indicates remaining distance from the MTO.
- Measurement challenges:
  - Structural balance (in level) is more problematic than its first-difference version because ex-post revisions of the output gap generally affect series levels rather than slopes.
  - A wide range of methodological options exist to address shortcomings; each has trade-offs.
  - Recommendation: give less prominence to the structural balance (in level) in the current framework and improve methodology until the risk of misjudging fiscal stance and resulting policy errors is sufficiently contained.

*Source: _wp1567 - Box 3. How Do Federations Constrain the Fiscal Policy of Sub-central Governments?_*

### Box 4. How To Move Forward with the Structural Balance Indicator?

### Box 4. How To Move Forward with the Structural Balance Indicator?

### Methodological improvements to reduce output-gap measurement error
- Multivariate filters that extract cycle information from additional observable variables (such as capacity utilization) are less exposed to the end-point problem (see Benes and others, 2010; and IMF, 2013a).
- The European Commission’s 2010 method uses capacity utilization data to help identify supply; these surveys do not get revised, which has lowered the spread between real time and mature output gap estimates by around 20 percent on average.
- The expenditure benchmark uses, as a reference rate of potential growth, the 10-year average of the series including 5 years of outturn, the current year and 4 years of forecasts—smoothing the series volatility and thus reducing the size of future revisions.

### Accounting for bias and notional correction mechanisms
- Bias could be explicitly accounted ex-ante by including an ad hoc adjustment factor in the structural balance formula and/or by conducting a study about the predictability of revisions to the output gap.
- Risks of ex-ante adjustments:
  - If bias arises from strategic political-economy behavior rather than exogenous technical flaws, introducing an adjustment may result in a larger bias to compensate for the adjustment.
  - The bias is unlikely to affect all countries equally; any adjustment would have to be tailored to each member country and possibly readjusted over time.
- Structural rule with notional account (Swiss debt-brake model):
  - A notional account records ex-post deviations between real-time and mature estimates.
  - When cumulative deviations exceed a threshold, correction measures would have to be taken (for instance by cutting spending to realign it with the lower-than-initially estimated potential GDP).

### Alternatives to the structural balance indicator
- Replace with an indicator that mimics structural-balance properties without relying on output-gap estimates:
  - Example: “augmented growth-based balance rule” extracts cyclical effects from the nominal balance by using the difference between economic growth and trend growth (IMF, 2009).
  - Downsides: lacks strong theoretical underpinnings and may entail a procyclical stance.
- Abandon the structural balance entirely in favor of an expenditure rule with a debt-linked correction mechanism:
  - Debrun and others (2008) propose replacing it with an expenditure rule that includes a correction mechanism associated with the debt level.
- Simpler rules with limitations:
  - The 3 percent deficit rule is easy to monitor but has weak economic rationale and entails large costs when it fosters a pro-cyclical fiscal stance.
  - The 1/20th debt reduction benchmark is dominated by the structural balance rule; it would become redundant if the structural balance were used to determine the necessity of an EDP, as suggested earlier.
  - Measurement errors and uncertainties affecting potential output and structural budget balance estimates could argue in favor of maintaining the 1/20th debt rule—as an objective and simple benchmark for consolidation progress.

### How to better coordinate fiscal policy monitoring
- Formal two-way exchanges between national fiscal councils and the Commission could reduce conflicting assessments.
  - The Commission can provide guidance on technical (e.g., calculation of the output gap) and procedural (e.g., allocation of structural balance targets across government levels) issues.
  - Fiscal councils can provide independent views, easier access to information, and knowledge of country-specific institutional details.
- Institutional structures for cooperation:
  - Minimal approach: institutionalize and intensify mutual exchanges through regular multilateral meetings (for instance in the context of the EUNIFI network).
  - Deeper cooperation could be complicated by many actors and the Commission’s political nature; risk that the network is perceived as a channel of supranational influence on national councils argues for a stand-alone coordinating body representing individual councils.
  - More ambitious proposal: creation of an EU-wide council reporting directly to the European Parliament (Fatás and others, 2003), which could substitute for or complement national councils; limited current interest in creating new European institutions.

### Strengthening enforcement: two main directions
- Overall approaches:
  1. Reinforce the existing supranational framework by stepping up procedures, correction mechanisms, and sanctions, while making them more automatic.
  2. Rely on alternative/complementary mechanisms to promote fiscal discipline, such as stronger market oversight or transfer of fiscal powers to the center.

- Strengthening existing enforcement:
  - Introduce more automaticity in moving up steps after a rule is breached and the breach is acknowledged; accelerate procedural steps in well-defined circumstances (e.g., misreporting).
  - The imposition of sanctions should remain the result of a discretionary decision based on sound economic judgment.
  - Institutional options:
    - Increase the role of the Commission by placing the decision to impose sanctions directly in its hands, with only a veto right from the Council decided at unanimity.
    - Alternatively, require the Council to publicly justify (for instance before the European Parliament) why it deviates from a Commission’s recommendation (IMF, 2010).
  - Broader set of sanctions:
    - Financial sanctions in bad times lack credibility because they exacerbate financial difficulties; hence, impose financial sanctions only in good times (e.g., reduced access to structural funds and other EU subsidies).
    - Consider non-pecuniary sanctions in bad times (e.g., administrative sanctions like personal sanctions or constraints on new staff hire; political sanctions like limitation of voting rights, subject to political and democratic constraints).

- Offsetting past deviations and the debt-brake model:
  - Current practice: countries breaching the 3 percent rule or the MTO are required to bring the deficit back below the ceiling, but past deviations’ effect on debt do not need to be corrected subsequently, creating a risk that debt ratchets up over time until it reaches 60 percent of GDP.
  - Debt brake example (Swiss model):
    - Specifies a one-year ahead ex-ante ceiling on central government expenditure equal to predicted cyclically adjusted revenue, effectively corresponding to maintaining a structural budget balance every year.
    - Differences between budget targets and outcomes are recorded in a notional account.
    - If the negative balance in the account exceeds a threshold, authorities are required to take measures sufficient to reduce the balance below this level within three years.
  - Criticisms and balanced approach:
    - Debt brakes can impose unrealistic adjustments following large slippages because the fiscal position must not only return to the target but overshoot it to correct the account.
    - Never offsetting past deviations is misguided because debt eventually increases until the debt ceiling becomes binding.
    - A more balanced approach: target a gradual correction for countries with a debt below 60 percent of GDP, achievable by proper calibration of fiscal rule formulas (IMF, 2009).

### Market discipline versus central controls
- Strengthening market oversight and discipline:
  - Enforcement is stronger when financial markets penalize countries that breach fiscal rules.
  - The Maastricht provision to prevent member states from assuming other member states’ fiscal commitments (Article 125 of the TFEU—the “no bailout” clause) was intended to give markets an incentive to discriminate and price each member state’s default risk.
  - Market discipline has not worked properly in the EMU due to:
    - Lack of credibility of the no-bailout provision since EMU inception.
    - Scale of the financial crisis requiring creation of risk-sharing institutions such as the European Stability Mechanism.
    - Sovereign-bank link distorting the pricing of risk by markets (Allard and others, 2013).
  - Restoring market discipline and mitigating moral hazard are long-term tasks requiring conditions such as clear rules for private creditor involvement in bailouts (e.g., EU Bank Recovery and Resolution Directive).
  - Transition to such a regime must be gradual and coordinated to avoid abrupt moves in investors’ portfolios and bond prices.

- Reliance on central controls:
  - Interim or long-term enforcement may be imposed more directly by the center, potentially at the expense of permanent loss of fiscal sovereignty for euro area members (for instance, a veto power of the center on national budgets).
  - A thorough analysis of deeper fiscal integration options is beyond the scope of this box (see Allard and others (2013)).

### Conclusion highlights relevant to the structural balance issue
- The European fiscal governance system still faces challenges: complex fiscal-rule design and weak enforcement mechanisms.
- Fiscal governance must be strong ex-ante; preventing fiscal imbalances is often more effective and easier than correcting them ex-post.
- Preventive arm of the Pact should be more effective in enforcing structural balance targets and limiting the ability of member states to spend revenue windfalls in good times.
- Reforms should be sequenced, weighing priority against practicability:
  - Medium-term objectives: tackle complexity of the framework and enhance enforcement (may require rethinking overall structure and consolidating preventive and corrective arms).
  - Lower-priority but tractable tasks: enhance monitoring (e.g., create a discussion forum with fiscal councils).
- Broader economic governance improvements are needed to address private-sector imbalances and competitiveness divergence:
  - Private imbalances can become public liabilities (examples: Ireland, Spain).
  - The Macroeconomic Imbalance Procedure considers private debt, external current accounts and net international investment positions.
  - The banking union and the bail-in regime help align incentives in the financial sector and reduce taxpayer exposure to banking sector losses.

*Source: Box 4. How To Move Forward with the Structural Balance Indicator? (_wp1567).*

### 0.5 percent of GDP per year in structural

### _wp1567 - 0.5 percent of GDP per year in structural

### Reform features and fiscal rule design
- Adjustment path defined as adjustment of 0.5 percent of GDP per year in structural terms.
- Progress towards MTO is also assessed with an expenditure benchmark.
- Quantification of "large deviations" from MTO or path towards it is included.
- Escape clauses:
  - None (in the basic specification).
  - Deviations are possible if structural reforms with short-term budgetary cost.
  - New escape clauses for unusual events with major budgetary impact and for general crisis.
- Monitoring and assessment:
  - European Commission (EC) and European Council monitor implementation.
  - European Semester used for assessment.
  - Assessment of euro area MS draft budgets in the Fall.
  - Monitoring by fiscal councils.
- Enforcement features:
  - Corrective actions: EDP recommendations remain the corrective action mechanism.
  - Sanctions:
    - Initially: financial sanctions at the very end of the procedure.
    - Reforms introduced early and gradual financial sanctions for euro area countries in later stages, with new voting procedures to enforce sanctions.
  - For the corrective arm: annual adjustment of at least 0.5% of GDP in structural terms; new indicator of "adjusted fiscal effort".
  - For pluriannual EDP, intermediate objectives are binding. Possible deadline extensions if fiscal effort is delivered; deadline extensions in case of general crisis.

### Rules and specifications (Preventive and Corrective arms)
- Rule headline: Member States (MS) should not have "excessive deficits".
- Deficit specification:
  - Deficit below 3% 1/.
  - Later: Deficit below 3% or, if debt above 60%, should be sufficiently diminishing based on 1/20th criterion.
- Exceptional circumstances / escape clause thresholds:
  - Exceptional circumstances defined as GDP contracting by 2% a year (earlier specification).
  - Exceptional circumstances redefined as negative output gap or protracted below-potential growth (later specification).
- Footnotes:
  - 1/ Debt criterion was initially not implemented, because not defined precisely.
  - 2/ Six-pack and European Semester.
  - 3/ TSCG and Two-pack.

### Euro area fiscal outcomes: key aggregates (selected series)
- Table A.3. Euro Area: General Government Overall Balance, 1999-2013 (Percent of GDP)
  - Euro Area (18): -1.5 -0.1 -2.0 -2.7 -3.2 -2.9 -2.5 -1.4 -0.7 -2.1 -6.3 -6.2 -4.1 -3.7 -3.0
- Table A.4. Euro Area: General Government Debt, 1999-2013 (Percent of GDP)
  - Euro Area (18): 71.6 69.2 68.2 68.0 69.2 69.6 70.5 68.6 66.2 70.1 79.9 85.7 88.1 92.7 95.0
  - Note: Red cells indicate public debt above 60 percent of GDP.
- Table A.5. Euro Area: General Government Structural Balance, 1999-2013 (Percent of potential GDP)
  - Euro Area (18): -1.8 -1.1 -3.0 -3.2 -3.4 -3.1 -2.8 -2.3 -2.2 -3.0 -4.5 -4.4 -3.5 -2.1 -1.3
  - Note: Figures refer to cyclically adjusted balance for data prior to 2003.
  - Note: Red cells indicate structural deficit above 0.5 percent of potential GDP.

### Debt decomposition methodology (Appendix 1)
- Main recursive equation governing debt ratio dynamics:
  - Debt level at end of period t: d_t; primary balance (ratio to GDP at t): pb_t.
  - Dynamics combine:
    - An “interest rate-growth differential” term (decomposable into interest effect i_t and growth effect G_t),
    - The primary balance pb_t (decomposable into cyclical component, cyclically adjusted primary balance (CAPB), structural balance, and one-off terms),
    - A residual stock-flow adjustment term.
- Multi-period decomposition: expand one-period equation to sum contributions over periods (example: decomposition of debt changes between 2007 and 2013 into interest-growth differential, primary balance, and stock-flow adjustment). This decomposition forms the basis for the debt decomposition exercise reported in Table 1.

### Procyclicality of fiscal policy in the euro area (Appendix 2): narrative findings
- The nominal fiscal deficit rule (3 percent ceiling) can create a pro-cyclicality bias:
  - During upturns: the 3 percent ceiling is unlikely to bind, so it does not compel fiscal tightening to build buffers—this can lead to procyclical loosening.
  - During downturns: the rule may force consolidation when fiscal stimulus is needed.
- Panel analysis (18 euro area countries) separates two sub-periods: pre-EMU (1981-1998) and EMU (1999-2013).
  - Fiscal policy prior to 1999: tended to be slightly counter-cyclical (CAPB response to output gap positive though small and statistically insignificant).
  - Since 1999 (EMU): fiscal stance shows a pro-cyclicality bias on average, with asymmetric behavior:
    - Upturns (positive output gaps): countries tended to reduce the CAPB (both level and first difference), indicating procyclicality.
    - Downturns (negative output gaps): countries loosened the fiscal stance when the output gap declined, indicating countercyclical policy during downturns.
- Instrumental variable estimation (instrumenting current output gap with previous year output gaps in individual countries and in the euro area) confirms a strong procyclical bias during upturns under EMU.
- These findings broadly align with prior studies cited (e.g., Cimadomo 2005; Deroose and others 2008).

### Empirical results: selected econometric coefficients (tables A.6–A.8)
- Table A.6. Cyclical Sensitivity of the Structural Fiscal Effort (Dependent variable: ∆CAPB; Panel fixed effect estimator)
  - Debt/GDP (t-1):
    - 1981–2013: 0.029*** (0.008)
    - 1981–1998: 0.032*** (0.008)
    - 1999–2013: 0.055*** (0.014)
  - Output gap(t-1)*ind(gap>0):
    - 1981–2013: -0.169** (0.077)
    - 1981–1998: 0.094 (0.170)
    - 1999–2013: -0.186** (0.091)
  - Output gap(t-1)*ind(gap<0):
    - 1981–2013: 0.088 (0.077)
    - 1981–1998: -0.066 (0.188)
    - 1999–2013: 0.165* (0.098)
  - Note: *,**, and *** indicate statistical significance at 10%, 5% , and 1% level, respectively.
- Table A.7. Cyclical Sensitivity of the Structural Fiscal Balance (Dependent variable: CAPB; Kiviet dynamic estimator)
  - CAPB (t-1):
    - 1981–2013: 0.731*** (0.056)
    - 1981–1998: 0.718*** (0.054)
    - 1999–2013: 0.753*** (0.075)
  - Debt/GDP (t-1):
    - 1981–2013: 0.021** (0.011)
    - 1981–1998: 0.025** (0.010)
    - 1999–2013: 0.024 0.033** (0.017) (note: two reported columns)
  - Output gap(t-1)*ind(gap>0):
    - 1981–2013: -0.193** (0.085)
    - 1981–1998: -0.004 (0.169)
    - 1999–2013: -0.217** (0.103)
  - Output gap(t-1)*ind(gap<0):
    - 1981–2013: 0.162* (0.100)
    - 1981–1998: 0.066 (0.184)
    - 1999–2013: 0.192** (0.115)
  - Note: *,**, and *** indicate statistical significance at 10%, 5% , and 1% level, respectively.
- Table A.8. Cyclical Sensitivity of the Structural Fiscal Effort, IV Estimation (Dependent variable: ∆CAPB; Instrumental variable estimator)
  - Debt/GDP (t-1):
    - 1981–2013: 0.031*** (0.008)
    - 1981–1998: 0.033*** (0.009)
    - 1999–2013: 0.058*** 0.066*** (0.014) (two reported columns)
  - Exp. output gap (t)*ind(Exp. gap>0):
    - 1981–2013: -0.226** (0.122)
    - 1981–1998: 0.056 (0.284)
    - 1999–2013: -0.294** (0.144)
  - Exp. gap (t)*ind(Exp. gap<0):
    - 1981–2013: 0.133 (0.105)
    - 1981–1998: -0.032 (0.257)
    - 1999–2013: 0.251** (0.130)
  - Note: *,**, and *** indicate statistical significance at 10%, 5% , and 1% level, respectively.
  - 1/ Expected value of the current output gap based on instruments.
  - 2/ Interaction terms for upturns (OG>0) and downturns (OG<0).

### Policy implications and interpretation (drawn from source analysis)
- Rigid nominal deficit ceilings (3% rule) can induce procyclical fiscal behavior by failing to require consolidation during booms and by constraining stimulus during downturns.
- Rules linking deficit targets to structural adjustments (e.g., 0.5 percent of GDP per year structural adjustment) and incorporating expenditure benchmarks aim to reduce procyclicality and improve medium-term sustainability.
- Escape clauses for structural reforms with short-term costs and for major shocks or general crises provide flexibility but require robust monitoring (EC, European Council, European Semester, fiscal councils) and clear enforcement mechanisms (EDP recommendations, financial sanctions, voting procedures).
- Empirical evidence indicates that debt dynamics are sensitive to both the debt/GDP position and cyclical conditions; higher debt/GDP (lagged) is associated with fiscal tightening (positive and significant coefficients on Debt/GDP (t-1) across specifications).
- The asymmetric response of fiscal policy to upturns and downturns since EMU suggests that rule design and enforcement should explicitly address incentives during positive output gaps to avoid procyclicality.

*Italicized source: Extracted from the provided IMF working paper content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2015/_wp1567.pdf_