Credit: The National Debt Clock on the corner of 43rd Street and Sixth Ave. in a 1992 file photo. On September 7, 2000 the clock will be shut off because the debt, after reaching a high of $5.78 trillion in 1999 started to decline to $5.68 trillion on September 1, 2000. The clock was started in 1989 by the late real estate developer Seymour Durst to raise public aeareness of the national debt. (© Frances M. Roberts) (Newscom TagID: lrphotos112516.jpg) [Photo via Newscom]

Fiscal Rules: Make them Easy to Love and Hard to Cheat

Xavier Debrun, Luc Eyraud,, Andrew Hodge, Victor Lledo , Catherine Pattillo, Abdelhak Senhadji

April 13, 2018

April 13, 2018

Versions in Español (Spanish), Français (French),  Português  (Portuguese)

[caption id="attachment_23227" align="alignnone" width="1024"] The national debt clock in New York City: a fiscal rule, like the debt ceiling, should not be set too low or too high. (photo: Frances M. Roberts/Newscom)[/caption]

Rules to contain lavish government deficits are most effective if countries design them to be simple, flexible, and enforceable in the face of changing economic circumstances.

In new analysis, we look at fiscal rules in over 90 countries and, based on their experiences, find that the rules put in the place over the last three decades often were too complex, overly rigid, and difficult to enforce.

Fiscal rules set the course for a government’s responsible fiscal policy. For example, a government can decide to limit its annual borrowing to 3 percent of the economy’s total income, as is the case in many European countries. Rules can help prioritize among the many demands on the budget, chart a predictable path for government policy, and keep public debt in safe territory.

The analysis shows that better-designed rules can help avoid excessive deficits, which hinder sustainable public finances. This reassures financial markets and investors, and, as a result, countries that comply with their fiscal rules can borrow more cheaply. Countries with excessive deficits and lax rules have higher borrowing costs because investors see them as more of a risk.

By demonstrating a government’s commitment to well-managed public finances, fiscal rules can create room in the budget to finance policies that promote growth, enhance the economy’s resilience to adverse shocks, and reduce excessive income inequality.

Past as prologue: lessons for rule design

Some key features have proved to enhance the rules’ effectiveness in the past:

Also, successful fiscal rules need political buy-in, as well as supporting institutions that enhance fiscal transparency and accountability—such as fiscal councils, which governments establish to act as public watch dogs to evaluate fiscal policy. Most European countries have, for instance, set up fiscal councils in recent years.

In the past decade, substantial reforms have led to a second-generation of rules. These are: first, more flexible, for example with new and better-defined exceptions; and second, easier to enforce, for example, by adding correction mechanisms that foresee what the government should do when they break the rule. Jamaica and Grenada have introduced correction mechanisms in 2014 and 2015.

However, we find that these innovations have made the rules more complicated to operate with no discernible impact on compliance yet.

Three principles for future reforms

To address these shortcomings, our analysis provides three principles to guide the design of new rules and the reform of old ones:

Of course, countries should tailor these three principles to their own circumstances.

The study also includes six background papers, which you can read here. They cover topics such as the evolution of rule design over time, their ability to contain deficits, and how countries have complied with rules in the past.

 

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