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The Design of Fiscal Policy Rules Principles and Cross-country

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The Design of Fiscal Policy Rules Principles and Cross-country Powered By Docstoc
					                        The Design Of
                        Fiscal Rules /1,2


                                  Davide Lombardo
                      International Monetary Fund
                   Turkish Banks’ Association Seminar
                                      February 26, 2009
1/ The views expressed in this presentation are the author’s, and not necessarily the IMF’s.
2/ Based on the December 1-2 2008 workshop organized by the Treasury, SPO, and MOF together with the Fiscal
Affairs Department of the IMF. In particular it borrows on the presentations by Debreu and Debreu and Kumar
(available on the website of the Turkish Treasury—see press release dated 18 Dec 2008).
                              Outline
   First principles: (Definition, Rationale, Function)

   Taxonomy

   Design trade-offs

   Basic properties of selected rules

   Monitoring and enforcement

   Fiscal rules around the world:
        EU sample
        Broader sample

   Lessons from stylized facts

   Conclusions
                        Definition
   Mechanism placing durable constraints on fiscal
    discretion through numerical limits on budgetary
    aggregates (expenditure, revenue, budget
    balance and/or public debt).

   Any fiscal policy rule is made of 3 parts:
       Numerical target/ceiling on one or more specific fiscal
        indicators
       Explicit cost for non-complying policymakers
       A monitoring/enforcement procedure.
What is not a fiscal policy rule?
   The annual budget is not a rule, as it only
    applies for one year.

   An IMF-supported program, as it is not expected
    to be a permanent feature of fiscal policy.

   The new UK ―rule‖: “To set policies to improve
    the cyclically-adjusted current budget each year,
    once the economy emerges from the downturn,
    so it reaches balance and debt is falling as a
    proportion of GDP once the global shocks have
    worked their way through the economy in full.”
       Rationale: why constraining discretion?
   Unconstrained fiscal policy may be perceived as
    systematically deviating from desirable policies. In practice:
    pro-cyclical and/or unsustainable policies.

   Reasons why unconstrained policies can be biased:
      Time-inconsistency

      Fiscal federalism/monetary union

      Political economy: Myopia, re-election concerns, fiscal

       illusion, distributive conflicts, and coordination failures.

   Other disciplining mechanisms?
      Markets: yes, but unreliable (comes too late and to

       strongly)
      Delegation to non-partisan technical agencies: poses

       considerable issues in terms of democratic accountability.
        Functions of fiscal rules
   Rules are commitment devices: they make
    deviations from socially desirable targets too
    costly for policymakers.

   Rules are signaling tools: they can help
    policymakers signal their genuine commitment
    to sustainable and stabilizing policies.

   Rules can also serve to anchor expectations,
    thus reducing uncertainties and risk premia.
         Principles of a taxonomy
   Many parameters enter the design of an actual
    fiscal policy rule:
       fiscal target(s)
       nature of costs in case of deviation
       monitoring/enforcement
       escape clauses, etc.

   A good rule must imply good policies in most (if
    not all) circumstances

     the policy response induced by the rule to a
      variety of shocks is therefore key.
Key feature of the rules: response to shocks

       to discretion make sense, but they
 Limits
 should NOT:
     Prevent adequate responses (e.g., let
      automatic stabilizers play in bad times)
     Force inadequate responses (e.g., force a
      fiscal contraction in response to a temporary
      spike in interest rate, or depreciation of the
      exchange rate)
     Let the bias unchecked in specific
      circumstances (e.g., allow for procyclical
      expansions).
         The design of fiscal rules
   There is no one-size-fits-all fiscal policy rule.
    Much depends on:
       Constellation of shocks prevalent in the economy
       Nature and magnitude of policy bias under discretion.
   A good rule is (Kopits and Symansky, 1998):
       …simple
       …transparent
       …coherent with the final goal
       …but mindful of other goals of public policy:
         • Not discouraging structural reforms
         • Allowing for fiscal stabilization (time-frame, cyclical
           adjustment)
         • Avoiding low-quality adjustments (undue tax hikes, cuts in
           quality/priority spending).
             Two key trade-offs
   Credibility-flexibility: allowing for greater
    responsiveness to shocks could undermine
    credibility of attaining the final goal.

   Flexibility-simplicity: combinations of rules can
    relax somewhat the credibility-flexibility trade-off,
    at the cost of simplicity and transparency.

 The devil is in the details
           Other design issues
   Coverage of the government sector

   Policy coordination in federal/decentralized
    systems

   Legal foundations

   Need for adequate budgetary procedures
    (preparation, execution, and ex-post auditing of
    budgets)

   Need to limit scope for creative accounting
Pros and cons of selected rules
   Simple rules:
       Debt rules
       Budget balance rules
       Expenditure rules
       Revenue rules


   Combined rules: e.g., debt objectives coupled
    with binding deficit ceilings, debt/budget balance
    objectives coupled with binding medium-term
    expenditure ceilings
                    Deficit Rules
Balanced budget and overall deficit limits
 Pros:
    pin down asymptotic properties of debt

    directly address the deficit bias

    can be simple and transparent (unless cyclical

     considerations, escape clauses, etc).

   Cons:
      procyclical (unless cyclically adjusted or ―over the cycle‖)

      could force cut in investment…

        •  golden rule, but these open door to manipulations,
          and do not guarantee debt sustainability.

   Overall vs. primary balance?
    Primary is more robust to volatility in interest payments.
                   Debt Rules
Upper limit (or desirable time path) for gross or net public debt

   Pros:
      Directly tackle debt sustainability

      Can be transparent and simple

      Can accommodate large shocks if debt is well below the
       ceiling

   Cons:
      Lack controllability

      Can force procyclical and undesirable responses to
       interest rate and exchange rate shocks if debt is close to
       the limit

   Borrowing constraints generally applied at regional and local
    levels
            Expenditure Rules
Set expenditure ceilings (nominal or in terms of
GDP) or limits on growth (nominal or real).
Pros:
   tackle one of main source of deficit bias

   translate directly into budget preparation

   minimizes pro-cyclicality risks

   fosters medium-term planning

Cons:
   May leave room for discretionary tax cuts 

     sustainability?
   complex to design (nominal vs. real,

     exclusions,…)
Best used in combination with deficit or debt rules.
                 [Revenue Rules]
   Rules imposing limits on revenues with a view to:
       Contain size of the public sector / tax burden
       Allocate ex-ante revenue windfalls (e.g., due to surprisingly
        high growth)

   Pros:
       Can reduce procyclicality in good times

   Cons:
       Limited impact on deficit bias if not coupled with other rules
       Can be procyclical in case the rule targets a given revenue-to-
        GDP ratio (due to the progresssivity of the tax system)
           Combination of rules
   Drawbacks with individual rules have led most
    countries to adopt combination of rules

   Most common combinations:
     Debt and overall deficit ceiling and overall

      balance target (e.g., Maastricht)
     Overall balance and expenditure ceilings

      (Sweden, Finland, Netherlands, etc).
                    Monitoring
 Ex-ante    auditing:
     Is the government proposed fiscal policy
      consistent with the rule and its objectives?

 Ex-post    assessment:
     Was the rule implemented?
       • Analysis of underlying policies
       • Certification role: track attempts to resort to
         creative accounting
       • Assessment of ex-post adjustments to the target
         (CABs,…), activation of escape clauses, etc.
            A key pre-requisite
Budgetary transparency:
     Fiscal data need to be accessible, timely, and
      reliable
     Comprehensive periodic reporting requirements
     Clarity about the budget preparation and
      execution procedures
     Clarity about roles and responsibilities of
      different levels of government
               Fiscal councils
 Independent     institutions with
     country-specific mandates
     adequate and highly qualified staff
     guaranteed multi-year budget.
 Can contribute to greater transparency
  and accountability of fiscal policy.
 Can help monitoring and enforcing a rule.
                  The case of Chile
   Fiscal institutional setup designed to buttress fiscal
    sustainability and dampen cyclical fluctuations.

   Rule: maintain a structural surplus of 1 percent of GDP
    for the central government. Fiscal expenditures follow
    the dynamics of structural revenue.

   Two independent expert panels provide key projections:
    1.   the inputs (growth of the labor force, real investment, and total
         labor productivity) for estimating trend GDP
    2.   ten-year forecasts of the price of copper.

   Independent panels enhance policy credibility, while
    allowing some policy flexibility.
        The case of the Netherlands

   The Central Planning Bureau plays a key role in
    the budgetary process:
       Provides projections and forecasts
       Estimates desired structural budget balance
       Vets the programs of all political parties (which are
        thus subject to reputational sanctions)
       Undertakes analysis of specific budgetary projects.


   High credibility borne out of tradition
 Fiscal Rules: International Experience

 Stylizedfacts for EU (EC database: annual
 data over 1990-2005), and the rest of the
 world (IMF-FAD database on the design
 and implementation of fiscal rules)

 Worldwide: 81 countries identified as
 having fiscal policy rules, with complete
 information for 77 of them
Growing appetite for fiscal rules (EU)
            0.90
                          Maastricht                  SGP      EMU
            0.80


            0.70


            0.60
Raw index




            0.50


            0.40


            0.30


            0.20                                                                          EU-15
                                                                                          Euro-11

            0.10                                                                          NMS
                                                                                          Big-4

            0.00
                   1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
               Emerging Market and LICs are
             catching up with industrial countries
        Number of fiscal rules by category of countries: 1990-2008
80
     Industrial
     EU-27
70
     Emerging

60   LIC's


50

40

30

20

10

0
     1990                 1995                 2000                  2008
Budget-balance and debt rules dominate, but
 expenditure rules are increasingly popular
     Number of countries with at least one fiscal policy rule (by type of rule)
80
        Budget balance

70      Debt
        Expenditure
60      Revenue


50

40

30

20

10

0
        1990                  1995                  2000                  2008
     Expenditure and revenue rules are thus relative
                      newcomers

                  Median duration of existing fiscal rules (in years)
10

9

8

7

6

5

4

3

2

1

0
     Budget balance             Debt               Expenditure          Revenue
                             Same trends in EU sample
60




      Revenue Rules
50    Expenditure rules
      Debt Rules
      Budget balance rules


40




30




20




10




0
     1990   1991   1992      1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003   2004   2005
Budget balance rules appear stronger and have wider coverage

                   Selected features of rules-based fiscal frameworks by type of rule
                                         (common features only)
            Budget balance
    1.00
            Debt
    0.90    Revenue
    0.80    Expenditure

    0.70
    0.60
    0.50
    0.40
    0.30
    0.20
    0.10
    0.00
               Independent           Independent           Coverage (median Statutory basis (median
           enforcement (relative   monitoring (relative   relative to maximum relative to maximum
                frequency)            frequency)             possible score)     possible score)
      This is reflected in synthetic measures
             of strength and coverage
          Indices of strength (max= 6) and of coverage (max=4) by type of rule
 3                                                                                          4.0
                                                                                 Strength
                                                                                 Coverage   3.5
2.5
                                                                                            3.0
 2
                                                                                            2.5


1.5                                                                                         2.0

                                                                                            1.5
 1
                                                                                            1.0

0.5
                                                                                            0.5

 0                                                                                          0.0
      Budget balance          Revenue                Debt              Expenditure
Strength and coverage relatively similar across countries

       Indices of strength (max= 6) and of coverage (max=4) by country category
 3.0                                                                                  4.0
        Strength       Coverage

                                                                                      3.5
 2.5

                                                                                      3.0

 2.0
                                                                                      2.5


 1.5                                                                                  2.0

                                                                                      1.5
 1.0
                                                                                      1.0

 0.5
                                                                                      0.5


 0.0                                                                                  0.0
        Industrial         Resource rich            LICs           Emerging markets
 Features by country groups
                        Selected features of rules-based fiscal frameworks
                             (relative frequencies by country groups)
1.00
           Industrial      Emerging        LIC's      Resource-rich
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
       Independent       M TEF      Independent FRL (all rules) Provision(s)    Exclusion of Independent
        enforcement    (relative to forecasts (all                for fiscal    high-quality monitoring (all
       procedure (all BBR and DR)       rules)                  stabilization     spending      rules)
           rules)                                                (relative to    (relative to
                                                                    BBR)        BBR and ER)
  Fiscal rules lower interest rates (EU-25)
                                            Table 2. Determinants of Long-Term Interest Rates in the EU-25 (1990–2005): Selected Sub-Samples

                                           Estimator:                                                   Arellano-Bond                                                             Fixed effects 1/
                                                                                                                                                                  No                        Unstable
                                                         EU-15          Non-EU15       Euro       Non-euro      High debt        Low debt     Delegation                      Stable gov.
                                                                                                                                                              delegation                      gov.

Long-term interest rate (lagged)                           0.55   ***     0.35 ***      -0.11        0.53 ***       0.47   ***     0.31 ***      0.39   ***      0.39   ***       0.56 ***    0.13
                                                         (8.77)         (4.26)        (-1.44)      (5.67)         (9.98)         (6.35)        (4.52)          (4.58)           (6.41)      (1.53)
Short-term interest rate                                   0.26   ***     0.58 ***       0.50 ***    0.23 ***       0.26   ***     0.50 ***      0.40   ***      0.23   ***       0.12        0.43 ***
                                                         (4.23)       (16.99)        (10.52)       (3.07)       (11.32)        (13.49)         (4.29)          (2.56)           (0.92)      (6.93)
Cyclically-adjusted primary balance                       -0.08   **     -0.01           0.00       -0.03          -0.07   *      -0.04         -0.07           -0.05             0.03       -0.04
                                                        (-2.44)        (-0.03)        (-0.26)     (-0.39)        (-1.77)        (-0.82)       (-1.34)         (-0.88)           (0.56)     (-0.72)
Public debt (lagged)                                       0.01           0.00          -0.01        0.00           0.01           0.00          0.02   **       0.01             0.00        0.01
                                                         (0.73)         (0.22)        (-0.85)      (0.27)         (0.46)         (0.08)        (2.04)          (0.61)          (-0.29)      (0.88)
Real GDP growth                                            0.13   ***    -0.01           0.04 **     0.11 **        0.26   ***     0.04          0.06   **       0.09             0.07        0.11 *
                                                         (3.04)        (-0.06)         (2.14)      (2.38)         (4.29)         (0.91)        (1.93)          (1.39)           (1.63)      (1.80)
Inflation                                                  0.22   **     -0.07 *         0.11 **     0.22 *         0.45   ***    -0.04          0.01            0.33   ***       0.26 *      0.09
                                                         (2.10)        (-1.77)         (2.12)      (1.92)         (4.22)        (-1.07)        (0.17)          (2.70)           (1.88)      (1.18)
Enlargement (dummy)                                          …              …              …         0.03             …              …             …            -0.61               …           …
                                                                                                   (0.07)                                                     (-1.40)
Election year (dummy)                                       …               …            0.08 **     0.38            …               …           0.26            0.28             0.47 *       0.02
                                                                                       (2.17)      (1.40)                                      (1.48)          (1.00)           (1.76)       (0.11)
Stability and Growth Pact (dummy)                           …               …              …           …             …               …             …            -0.29             0.13        -0.96 **
                                                                                                                                                              (-1.30)           (0.56)      (-2.13)
Government stability                                        …               …          -0.03 **     -0.17 *       -0.21 ***        0.03         -0.18 ***       -0.16             0.14        -0.08
                                                                                     (-1.89)      (-1.85)       (-3.75)          (0.24)       (-3.69)         (-1.61)           (0.59)      (-1.19)
Ideological range of governing coalition                    …               …          -0.02         0.13 *          …               …          -0.14            0.11   ***       0.10         0.15
                                                                                     (-1.53)       (1.90)                                     (-1.42)          (2.71)           (1.52)       (1.65)
Fiscal Rule Index                                         -0.16            0.10        -0.09 *      -0.16         -0.17            -0.31 **     -0.10           -0.41   **       -0.06        -0.43
                                                        (-1.58)          (0.10)      (-1.63)      (-0.93)       (-1.37)          (-2.48)      (-1.06)         (-2.03)          (-0.50)      (-1.59)
Number of observations                                     213              47           72          155            107             153           72             148              148          104
Number of countries                                         15              10           12           25             15              22            9              19               24           21
Test for 2nd order autocorrelation (p-value) 2/           0.93            0.16         0.10         0.38           0.25            0.21         0.55            0.45               …            …
Sargan test (p-value) 3/                                  1.00            1.00         1.00         1.00           1.00            1.00         1.00            1.00               …            …

Note: The t-statistics are reported in parentheses (with superscripts *, **, and *** denoting statistical significance at the 10, 5 and 1 percent levels respectively). They are robust
to cross-sectional heteroskedasticity. All models include a constant and country effects (not reported). The latter are jointly significant at conventional confidence levels in all
equations. The enlargement dummy is equal to 1 for new member states, after they joined the EU. The SGP dummy is equal to 1 for euro area member states after 1998.
1/ Arellano-Bond estimation could not be obtained for one of the subsamples (lagged dependent variable highly insignificant and evidence of second-order autocorrelation).
The comparison is thus based on fixed-effects estimates.
2/ Arellano-Bond test of the null hypothesis of no autocorrelation of residuals.
3/ Test of the null hypothesis that identifying restrictions are valid.
                                                                                                                        Debrun and Joshi (2008)
Fiscal rules lower interest rates (EU-25)
  Table 3. Impact of the Fiscal Rules on Long-Term Interest Rates: Specific Features
             of the Rule (EU-25, 1990–2005, Non-Excessive Public Debt)


  Specific dimensions of fiscal rules as captured by sub-indices:

      Statutory basis                                                           -0.47 **
                                                                              (-2.07)      All key dimensions
      Independent body monitoring the rule's implementation                     -0.48 **
                                                                              (-2.07)
                                                                                           matter  Effective
      Independent body contributing to rule's enforcement                       -0.52 **   rules deliver lower
                                                                              (-2.01)
                                                                                           interest rates.
      Strength of enforcement procedure                                         -0.40 **
                                                                              (-2.03)

      Media impact of the rule                                                  -0.47 **
                                                                              (-2.23)
  Memorandum items:
      Overall fiscal rule index                                                 -0.45 **
                                                                              (-2.09)
      Expenditure rule index                                                     0.05
                                                                               (0.29)
  Notes: The t-statistics are reported in parentheses (with superscripts *, **, and ***
  denoting statistical significance at the 10, 5 and 1 percent levels respectively).
  Given that subindices are only available for the overall fiscal rule index and the
  expenditure rule index, the results, obtained with model (6) in Table 1, use the
  overall index but control for the effect of expenditure rules.

                                  Debrun and Joshi (2008)
                         Lessons
   Historical preference for deficit and debt rule

   But recently emergence of expenditure rules (in
    combination with BBRs and DRs)

   What explains the trends for more rules and
    more expenditure rules?
       Increasing realization that purely discretionary fiscal
        policies are inconsistent with sustainability (growing
        public debt)
       Mounting pressures from long-term issues: aging,
        global warming, etc.
       Regional monetary unions.
                 Conclusions
   Well-designed fiscal rules can help improve
    fiscal performance on average…

   …thus lowering risk-premia and interest rates on
    long-term government bonds.

   But: political commitment is key

   As are adequate public financial management,
    monitoring and enforcing systems.

				
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