Fiscal Rules: Theory, Practice and Implications for Bulgaria

Press Release, 23 February 2012

The Institute for Market Economics publishes a report on fiscal rules, the logic behind their implementation, and history of fiscal rules in several countries. The report also presents an overview of such rules in Bulgaria as well as suggestions for their improvement. This is a resume, the full report can be found here (Bulgarian only).

The debate for the most effective fiscal policy approach – rules vs. discretion, has been around for more than 150 years now.  Either approach has been favored by the establishment in different time periods. In recent years, more and more people have been warming up to the idea of introducing fiscal rules and restrictions on public finances. Naturally, the ongoing public debt crisis in some European member-statesand especially in the Eurozone, has weighed on the growing popularity of this view. Yet, when talking about fiscal rules, the topic should not be examined only in the light of the recent crisis but in the broader context of the inherent bias of most governments to run deficits and pile up public debt. The main causes behind this bias are political time inconsistency and myopia, as well as the ease of shifting the debt burden to future generation.

Fiscal rules can be divided into four categories according to the budget aggregate they target:

  • Budget balance rule: aimed either at the overall balance on cash/accrual basis; the structural/cyclically-adjusted balance; the accrued balance over the economic cycle/a period of several yearsor the primary balance.
  • Debt rule: sets a ceiling on public debt as a share of GDP and by definition is the most effective rule when trying to bring down debt to a predefined level.
  • Expenditure rule: sets a ceiling on overall, primary or current expenditure in absolute or in relative terms.
  • Revenue rule: sets an upper or lower bound on revenues, aiming either to increase receipts or to limit the tax burden.

The choice of rules depends primarily on the government that will be implementing them, its goals, and the specific biases the restrictions need to address. By definition fiscal rules are meant to ensure the sustainability of public finances, which translates into convergence of public debt to sustainable levels.Rules targeting the budget balance or the public debt level are most effective to that end. There are no limitations to the number of rules to be employed. A recent report of the IMF (2009) on 80 countries using at least one fiscal rule shows that ¾ of them have a budget balance rule and/or a debt rule.

Our report has examined the history and practice of fiscal rules in the US, EU, Switzerland, Germany and the UK in more detail. There are several conclusions that can be made unequivocally from the experience of the US with fiscal rules:

  • They reduce the government’s deficit bias;
  • Stricter rules are associated with higher surpluses in good years;
  • Fiscal rules help smoothen the business cycle by playing a counter-cyclical role.

Fiscal rules on a supranational level in the European Union can be found in the Revised Stability and Growth Pact, but due to the limitations on their implementation and enforcement of sanctions, these rules are regarded as “soft”. Although they are less binding in comparison to the reviewed national rules, it was thought that they would provide a useful mechanism for voters and markets to monitor and evaluate government’s fiscal policies, which would make them self-sufficient. Obviously this has not happened to date.

Along with the debate on increasing the role of fiscal rules, a parallel discussion on how to make sure rules are abided by is also taking place. One solution to the compliance problem is to introduce an automatic correction mechanism, which is present in countries such as Switzerland and also on state level in the US. There is also another possible solution on the table, that has been proposed by academics since the 1990s. This solution foresees the establishment of Independent Fiscal Agencies, also known as Fiscal Councils, modeled after independent central banks. Fiscal Councils can play a supplementary role to fiscal rules in several ways such as:

  • Monitor whether fiscal objectives are being met and analyzing whether a potential deviation from the fiscal targets is acceptable or not;
  • Monitor the structure of public expenditure so as to influence decision-making and prevent reductions in productive public expenditure and/or increases in unproductive expenditure;
  • Provide objective proposals for improvement in the applied fiscal rules
  • Provide independent macroeconomic forecasts which can be then used in the budget preparation procces by finance ministries and treasury departments.

The deficit bias is present both on national and sub-nationallevel, albeit for different reasons. Despite the differences between the two levels of government, fiscal rules can be fine-tuned so as to address deficit biases on sub-national level, too. It should be noted that the introduction of such rules does not reduce the flexibility of sub-national governments. Researches show that one of the key elements in overcoming the effects of economic crises is tax autonomy, which does not conflict with fiscal rules.

In Bulgaria fiscal rules have been in place since 2003 in different forms, but have usually targeted general government budget aggregates and gross debt. The most recent rules came into effect in the beginning of 2012 and set a ceiling of 40% of GDP for general government expenditure and of 2% for general government budget deficit.

In their current form,however, the fiscal rules do not take into account the specific structure of the general government’s budget or the peculiarities of the Bulgarian economy.  The reason is that the central government’s budget is highly vulnerable to cyclical developments. It has a specific structure relying more heavily on indirect, rather than on direct taxes. This structure has proven successful in combating tax evasion and boosting the accrual of capital base and the increase of employment rates in the country. This setting leads to a high correlation between budget receipts and the economic cycle, which coupled with “sticky” public expenditure, can easily cause deterioration in the fiscal position and failure to meet fiscal targets during economic downturns. This becomes even more pronounced in light of the lack of a cyclical component in public expenditure for the last 10 years, meaning governments have not been engaged in any anti-cyclical policy during the period.

Given the budget structure and the lack of any anti-cyclical policy, an alternative to the present fiscal rules is a rule for a cyclically-adjusted balanced budget for the general government.Evenwith such astricter rule, there are several other issues that need to be addressed in order to ensure a smooth functioning for current, as well as future rules. These include:

  • Does Bulgaria need fiscal rules for municipal budgets?
  • Will the introduction of automatic correction mechanisms help and if so, how to structure them?
  • Is a Fiscal Council needed for Bulgaria  and if so, how to guarantee its independence and boost its reputation?

For questions and comments:

Kaloyan Staykov, economist

(+3592)952 62 66, (+3592)952 35 03