Given the central role of fiscal policy in addressing both recent crises and future challenges, the call to reform fiscal governance in Europe resonates like never before.
Fiscal policy provides essential support when households and firms are hit by large shocks, such as the pandemic, or when monetary policy is constrained. However, that requires healthy public finances. High debt and rising interest rates are making it harder for governments to address today’s multiple priorities, including tackling extreme increases in the cost of living and addressing the climate emergency.
Against this backdrop, the European Union needs revamped fiscal rules that have the flexibility for bold and swift policies when needed, but without endangering the sustainability of public finances. It is critical to avoid debt crises that could have large destabilizing effects and put the EU itself at risk. This will require building greater fiscal buffers in normal times.
A new IMF paper proposes reforms to the EU fiscal framework to help manage the tremendous policy challenges.
The overhaul should be economically sound and politically acceptable, building on the lessons from several past attempts to improve the fiscal rules. It will be critical to balance the respect for the sovereignty of national fiscal policies while strengthening the incentives for adopting sound policies for the EU.
The proposal centers on three pillars: revamping numerical fiscal rules to take explicitly into account the fiscal risks countries face while having a clear medium-term orientation; strengthening national fiscal institutions to improve domestic debate and ownership of policies; and creating an EU fund to help countries better manage economic downturns and provide essential public goods.
Ambitious reforms needed
The existing rules have had some success, especially by increasing public awareness that fiscal deficits should be below 3 percent of gross domestic product, enhancing government accountability. But they have not prevented an undesirable buildup of public debt and fiscal sustainability risks among some members.
As we saw with the European sovereign debt crisis, these risks have threatened the stability of the monetary union in the past and continue to create vulnerabilities today. This is despite numerous efforts to refine the numerical rules and strengthen central oversight over the years.
To some extent, weak national institutions, political pressures and large negative shocks have led to poor compliance. Combined with design limitations of the framework, which sets ceilings on deficits in bad times without providing sufficient incentives to build buffers in good times, this has led to the build-up of fiscal imbalances. The framework has also fared poorly at stabilizing output and lacks tools to provide common public goods for member countries.
In response to the pandemic, in March 2020, the European Commission triggered the general escape clause—which allows a temporary deviation from the EU fiscal rules—enabling member countries to respond more forcefully and flexibly. But the increase in deficits has pushed debt levels even further above the Maastricht Treaty reference value of 60 percent of GDP in many countries, posing additional challenges in transitioning back to the existing rules.
The IMF’s proposal has three interconnected pillars:
The proposal should be seen as a package of interlinked elements to promote an effective reform. It requires a mutually reinforcing relationship between EU rules and national implementation, particularly greater domestic ownership of the rules and better alignment between country frameworks and EU rules. The former can only be achieved by balancing the needs of member countries with safeguarding them from negative spillovers from other parts of the union. This argues for a risk-based approach—the first pillar of the IMF proposal. The latter requires a stronger role for our second pillar: significantly upgraded national frameworks—including enhancing the capacity and mandates of independent fiscal institutions.
Amid extraordinary economic uncertainty and fiscal challenges ahead, reform of the EU fiscal framework cannot wait. The extension of the general escape clause through 2023 provides a window of opportunity to do just this; further delays would force countries to go back to the old rules with all of their problems. The opportunity should not be wasted.
More progressive taxes with fewer exemptions would help governments pay for immediate spending priorities and make societies fairer. Countries in the Middle East and Central Asia have a long history of using taxes to develop their economies and promote social inclusion. The first income tax can be traced back 5,000 years to Ancient Egypt. The Pharaohs used it to build granaries and feed the poor during shortages. Zakat, a payment obligation akin to a progressive tax that began in the 12th century, is still collected to fund social spending in Saudi Arabia and elsewhere.
Ending the health crisis and addressing its immediate fallout remains the top priority, but governments would also benefit from committing to fiscal responsibility. From the outset of the COVID-19 pandemic, governments have extended massive fiscal support that has saved lives and jobs. As a result, public debt has reached a historic high, although it is expected to decrease marginally in the next few years. These developments raise questions about how high debt can go without being disruptive.