Green Fiscal Rules? Challenges and Policy Alternatives

IMF Working Papers, June 21, 2024

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This paper studies the impact of green fiscal rules—designed to protect climate-related spending—on debt dynamics.
Simulations for an emerging-market economy show that green rules that exempt green spending from rule limits can:
- lead to unsustainable debt dynamics when the net zero emissions goal is pursued mostly using spending-based instruments (e.g., investment and subsidies); or
- imply that the rule would need to implicitly assume a large fiscal adjustment in the non-green budget, undermining the rule’s credibility.
The paper argues that building broad public consensus for a more comprehensive fiscal strategy is needed to address policy tradeoffs and long-term effects.
A more appropriate mix of climate policies, including actively employing carbon pricing, should be pursued within the overall setting of fiscal and debt objectives.
Developing ‘green’ medium-term fiscal frameworks would help integrate climate change considerations into fiscal policy design in a more comprehensive manner.

Green fiscal rules that exempt green spending from fiscal limits can weaken debt sustainability if climate objectives are achieved primarily through public spending (investment and subsidies).
To remain credible under such exemptions, the non-green budget would need to deliver large fiscal adjustments—an implicit and potentially unrealistic assumption.
The interaction between climate policy design (spending-based vs. pricing-based instruments) and fiscal rules critically affects debt dynamics and the credibility of fiscal frameworks.
Integrating climate considerations into medium-term fiscal frameworks (MTFFs) provides a more comprehensive approach than narrow exemptions in fiscal rules.

Avoid relying solely on expenditure exemptions in fiscal rules to protect climate-related spending without addressing broader fiscal and debt objectives.
Pursue a policy mix that emphasizes carbon pricing alongside targeted public investments and subsidies to reduce pressure on public debt.
Build broad public consensus for comprehensive fiscal strategies that explicitly tackle tradeoffs between climate objectives and debt sustainability.
Develop and adopt ‘green’ medium-term fiscal frameworks to systematically account for climate-related spending and long-term fiscal effects.

Scenario: Net zero pursued mostly using spending-based instruments (investment and subsidies)
- Outcome: Risk of unsustainable debt dynamics under green-rule exemptions.
Scenario: Rule assumes large fiscal adjustment in the non-green budget
- Outcome: Undermines rule credibility due to unrealistic implicit assumptions.