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Strenghtening Medium-Term Fiscal Frameworks Fabrizio Balassone Econpubblica – Università Bocconi Milano, 25 Marzo 2009 MTFF: definition & purpose definition: set of institutions, procedures and rules governing (constraining) the development of public finances over the medium term purpose: ensure fiscal discipline (sustainability & stabilization) and efficient use of resources work on MTFF combines economics, institutional knowledge and a fair dose of pragmatism JIQ Fiscal discipline means... maintaining a prudent budget balance to: ensure sustainability of public debt allow margins to face cyclical fluctuations and e unforeseeable events taking into account the degree of debt tolerance (Kumar & Ter-Minassian, IMF 2007) JIQ Why budget discipline and efficiency? fiscal discipline and efficiency maximize public sector (PS) contribution to economic growth and welfare fiscal discipline = prerequisite to PS functions budget constraint is nec. cond. for allocative efficiency low debt no financial fragility margins for stabilization efficiency + stability growth resources for redistribution NB discipline does not imply efficiency: need accountability budget transparency (informed and explicit choices) measurability of results (assessment) JIQ Spreads (Spilimbergo et al. IMF09) 350 Long-Term Government Bond Yield Spread vis-à-vis Germany 300 Greece 250 Ireland Basis points 200 Portugal Italy Austria Spain Belgium Finland Netherlands 150 100 50 France 0 1/1/07 JIQ 3/12/07 5/21/07 7/30/07 10/8/07 12/17/07 2/25/08 5/5/08 7/14/08 9/22/08 12/1/08 2/9/09 The building blocks of a MTFF 1. a stable long-term anchor for the public finances rooted in some measure of sustainability 2. a simple medium-term “rule” ensuring consistency between the fiscal stance and the long-term anchor 3. a transparent convention on the headroom to build into the fiscal balances to deal with adverse circumstances 4. a multi-year budget with top-down preparation and tight execution procedures 5. mechanisms to ensure prudent forecasts of macroeconomic and fiscal variables 6. reporting, monitoring, auditing tools to ensure accountability JIQ OUTLINE Why discretion needs to be constrained Issues in building a MTFF (and solutions?) A few remarks about Italy Summary JIQ I. Why Does Discretion Need to Be Constrained? JIQ The political economy of budget deficits opportunistic politicians & naive voters (Puviani, 1903; Buchanan & Wagner, variation 1: variation 2: AEI 77; Buchanan et al., 1986) myopic politicians (Alesina & Tabellini, RES 1990; Rogoff, AER 1990) intergenerational distribution (Browning, EI 75; Tabellini, NBER 90, JPE 91; Cuckierman & Meltzer, AER 89) time inconsistency (Kydland & Prescott, JPE 77; Eichengreen et al., OER 99) common pool (Eichengreen et al., OER 1999; Velasco, 1999) variation 1: federalism (Buchanan, 1967; Oates, 1979; Weingast et al. JPE81) variation 2: monetary union (Balassone & Franco, JPFPC02) strategic use of the budget (Persson & Svensson, QJE 89; Alesina & Tabellini, RES 90; Tabellini & Alesina, AER 1990) coalitions & wars of attrition (Roubini-Sachs, EP89; Alesina-Drazen, AER91; Balassone-Giordano, PC01) JIQ Some evidence of the propensity to deficit finance General Government Overall Balance (in percent of GDP, weighted with GDP at PPP, 76 countries) 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 World Advanced economies Developing economies Sources: WEO database and fund staff calculations. JIQ It gets worse in good times “voracity effect”: perverse interaction between abundance of resources and political economy factors (common pool, myopia…) (Lane & Tornell, AER 1999; Debrun, Hauner & Kumar, IMF 2007) growing supporting evidence (asymmetric procyclicality) (Buti et al. OREP98; Buti & Sapir 1998; Balassone & Francese, TD04 & TD08; European Commission, 2006) coming mostly from expenditure (Kaminsky et al., NBER04; Hercowitz and Strawczynski, RES04; Balassone, Francese, Zotteri, TD08) JIQ Can we rely on markets? Theory (Bishop et al., 89; Lane, SP 93) Practice • No privileged access • Full information • • • No bail-out • Timely Signals • Sensitivity to signals • • • CB Independence Issue of information quality remains (Balassone, Franco, Zotteri, E06) Credibility of the clause? (IMF97) Not always (Ferri et al., EN99) Low and delayed (Balassone, Franco, Giordano, BI04) Fitch Ratings (2004) : “15-20 basis points […] is perhaps the most that could be attributed to credit differentials between AAA and AA euro-area governments [and] such amounts hardly seem likely to keep a German finance minister awake at night” (p. 6). JIQ The quality of information Italy - 2001 deficit outturn: estimates over time (as a percentage of GDP) 3.5 3.0 2.5 2.0 1.5 1.0 March 2002 JIQ June 2002 July 2002 February 2003 March 2005 May 2005 March 2006 The quality of information Greece - 2003 deficit outturn: estimates' over time (as a percentage of GDP) 6.0 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 March 2004a JIQ March 2004b May 2004 Sept. 2004 March 2005 Sept. 2005 II. Issues in Building a MTFF JIQ The broad definition of fiscal discipline fiscal discipline = prudent budget balance to: ensure sustainability of public debt allow margins to face cyclical fluctuations and unforeseeable events taking into account the degree of debt tolerance Problems: 1. defining debt “sustainability” 2. forecasting/measuring the economic cycle and its effects on the fiscal balance 3. quantifying implications of unforeseeable events (e.g. contingent liabilities - IMF 2007) 4. estimating the degree of “debt tolerance” (history? Reinhart, Rogoff & Savastano, NBER 2003) JIQ Debt sustainability (Banca d’Italia, 2000, 2004, 2006) intuition is clear: solvency debt repayment // but timing? limt→ dt = 0 moreover, theory says otherwise: “no Ponzi-game” limt→ dt [(1+)/(1+)]-t = 0 limt→ dt = | d’<(-) (Blanchard et al. OECD90; McCallum, JPE84) T<Y still leaves many options! (Barro JEP89; Kremers JME89, Domar AER44) JIQ Measuring the effects of the cycle cyclically adjusted balance (cab) cab = b - ε = (y-y*)/y* =b/(y/y) = (R R/Y - G G/Y – b) G/Y se R 1 e G 0 (Bouthevillain et al., ECB 2001: EU avg.: 0.9 and -0.2) problems different estimation methods return different values of estimates of subject to significant revisions (any method) estimation of elasticities far from straightforward is the output gap enough? (composition of output; other variables) JIQ Dispersion in OG estimates large in levels, less so in changes JIQ (Orphanides e Van Norden, RES 2002) OG estimates: Dispersion and Revisions JIQ Why the revisions? Y* (hence CAB) = f (Y past & future) – therefore: - revisions of forecasts influence the assessment of past outturns - the effect can be large in the proximity of turning points Example: 2001 fiscal balances in France and Germany JIQ Elasticities data intensive institutional knowledge vs. econometrics (reforms) identification of macroeconomic proxies for tax bases (e.g. profits) JIQ Output composition e.g. exports and domestic demand have different tax implications (Momigliano & Staderini, BI98; Bouthevillain et al., ECB01; Marino et al., QEF08) JIQ A pragmatic approach In sum: theory does not provide full guidance in defining both the long-term anchor and the medium term rule for a MTFF Need a pragmatic approach: Define “prudent” debt levels somewhat ad hoc (UK-EU) but not too different from proposals by theorists (Blanchard ES90, Buiter EP85…) Derive corresponding “structural” deficit targets - based on long-term expenditure projections - use sensitivity analysis (sustainability reports – Norway; EPC ageing working group 2006) Define medium-term / “over-the-cycle” targets with escape clauses in the face of unfavorable circumstances (Sweden; UK code of fiscal conduct; …) JIQ A few examples JIQ The design of fiscal rules Rules = commitment-devices and signaling tools (they increase the costs of deviating from the target for policymakers and reduce public’s uncertainty about policymakers’ commitment) Constrain the bias but mindful not to: √ introduce excess rigidity and prevent adequate responses (e.g. let automatic stabilizers play in bad times – balanced budget rule?), √ force inadequate responses (e.g. 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 – medium-term/over-the-cycle formulations like the (old?) SGP and UK code of fiscal conduct) JIQ Other issues of “design” JIQ √ some rules are not targeted to fiscal discipline (golden rule sustainability) √ window dressing (inconsistent deficit/debt indicators – SGP) √ some rules cannot stand alone (e.g. expenditure rules) Expenditure rules PROS: provide a stronger link between the long-term anchor and the multi-annual budget exercise tackle the bias at source (expenditure) let (revenue) automatic stabilizers play BUT cannot leave the revenue side unchecked (tax expenditure) MORE COMPLEX THAN IT SEEMS what about automatic stabilizers on the expenditure side? possible exploitation of planning margins? JIQ Tax expenditures - Sweden JIQ Exploitation of planning margins - Sweden JIQ III. Some Remarks about Italy JIQ The long-term anchor and the fiscal stance SGP: debt-to-GDP ratio = 60% but when? (“satisfactory pace” never defined) Often D/Y<100% targeted in official documents BUT on what basis? No sustainability report – setting medium-term deficit target? (long-term projections only for the EPC AWG) JIQ The medium-term rule EU: structural adjustment by ½ percent per year towards structural balance + free play of automatic stabilizers Truly endorsed? No explicit convention about headroom within the target JIQ As a consequence…. (A) General Government debt and deficit (% of GDP) 14 140 12 120 10 100 8 80 6 60 4 40 2 20 0 0 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 Indebitamento netto (as s e s inis tro) JIQ Debito (as s e des tro) As a consequence…. (B) Fonte: Banca d’Italia, Relazione Annuale 2007 JIQ Multi-year budget, top-down preparation, tight execution No “true” multi-year budget (3 years but t+1 and t+2 are forecasts, not binding plans) No top-down budgeting (no expenditure ceilings) Rather lax execution (no explicit contingency reserve but weak link between authorizations from the state budget and accounts relevant to the fiscal targets) (possibility to use “windfall revenues” to increase expenditure) JIQ As a consequence…. Contributions to deficit reduction (% PIL) Deficit reduction mostly from higher revenues and lower interest exp. JIQ Prudent forecasts - Accountability Insufficient information on fiscal projections on a current programs basis & on costing of new legislation Difficult to assess outturn No formal assignment of independent assessment (plus nothing much happens if targets are not met) Budget and legislation by line-items not programs Not surprisingly the 2007/2008 spending review found abundant evidence of inefficiency in the use of public money (CTSP08) JIQ A few examples Ministry of Infrastructures – Regional Offices: staff per billion of assets (CTSP08) 200 180 160 140 120 100 80 60 40 20 0 La-Ab- Si-Cal Sa JIQ CamMo VeTAAFr Pu-Ba ER-Ma To-Um Lo-Li Pi-VdA A few examples 0 50000 100000 150000 200000 Ministry of Justice – Prisons: Expenditure per inmate vs. number of inmates (CTSP08) 0 500 1000 Inmates JIQ 1500 A few examples Ministry of Justice – Courts: Elasticity of scale (yertical) vs. Number of Judges (horizontal) – (CTSP08) JIQ Education: resources vs. outcomes An inverse correlation between resources and outcomes (Montanaro, QEF08) Proficiency levels (primary and lower secondary schools (INValSI) Teachers per pupils Darker colors = higher values JIQ Health Services: Resources vs. Activities Another inverse correlation (Francese & Romanelli, BI09) Expenditure per resident (adjusted for the composition of population) Darker colors = higher values JIQ Patients’ mobility IV. Summary and Conclusions JIQ 1. There are significant incentives to fiscal indiscipline (both theory and evidence) 2. This entails both macro-risks and micro inefficiency 3. MTFFs can help re-engineering incentives and control risks: they are not a magic wand but one is better-off having them (issues in design & enforcement) 4. Italy: EU fiscal rules provide a frame but content needs to be defined at the national level JIQ 1st on the “to-do-list”: Improve Accountability “Educate the public”: set credible objectives, openly discussed and clearly communicated to population at large (e.g. sustainability reports) Ex post reconciliation of changes from one budget to the next Parliamentary scrutiny of financial performance Range of sanctions for persistent “overspenders” JIQ What Others Do EX ANTE • External scrutiny of economic assumptions (UK) • Use of consensus economic forecast (Canada) • Independent evaluation of macroeconomic conditions and fiscal stance (Sweden) • Independent fiscal forecasts (Netherlands) JIQ EX POST • Transparent reporting of fiscal performance (UK, NZ) • Independent evaluation of fiscal compliance with objectives (Sweden) • Predetermined mechanisms for addressing deviations form forecasts (Switzerland) Medium-term Expenditure Frameworks Range of Advanced Country Models DISCIPLINE COVERAGE COUNTRY Soc Sec Debt Interest Local Gov’t % of public spending LEVEL OF DETAIL TIME HORIZON Rolling or Fixed Frequency of Revision AGGREGATE EXPENDITURE CEILINGS Finland Some No No 36% Total Spending 4 4 fixed Every 4 years Netherlands Yes No T’fers 80% 4 Sectors 4 4 fixed Every 4 years Sweden Yes No T’fers 64% Total Spending 3 2 fixed + 1 rolling Every year FIXED MINISTERIAL PLANS United Kingdom No No T’fers 59% 25 Depts 3 2 fixed + 1 rolling Every 3 years France No Yes No 31% 35 Missions 3 2 fixed + 1 rolling Every 2 years Yes 100% 20 Depts 267 Progs 3 Rolling Every year ROLLING PROGRAM ESTIMATES Australia JIQ Yes Yes 48 Effective Multi-year Expenditure Prioritization Mechanisms JIQ CHARACTERISTIC DEFINITION BEST PRACTICE Centralized No competing source of expenditure authority Australia Strategic Assumes policies, laws and contracts can be changed Netherlands Legitimate Combines “bottom-up” input from ministries with “top-down” engagement from politicians France Comprehensive Covers all expenditure over the whole planning horizon United Kingdom Capped Operates withing a fixed, multi-year budget constraint Sweden Definitive The final verdict from the “top of the office” Finland 49 Adjustment Mechanisms: Managing risks, pressures & shocks in a multi-year system 1. Exclusion Excluding volatile/non-discretionary items from the rule celing, such as: • debt interest • unemployment benefits • social security • earmarked revenues • local government (own resources) 3. Contingency Reserves Building contingency margins into expenditure projections or ceilings: • Netherlands: 0.25% • UK: 0.75 – 1% • Canada: 1.5 – 2% • Sweden: 1.5 – 2% • Australia: 1.5 – 5% 2. Adjustment Adjusting ceilings to accommodate real economy effects, such as: • inflation (Netherlands) • revenue windfalls (Netherlands, Canada) 4. Budget Architecture Capacity to absorb shocks: • max 20-30 main budget headings • each budget a mixture of discretionary and non-discretionary items • maximum flexibility to reallocate • ministerial contingency reserves • mandatory savings targets 50 JIQ Once again on public scrutiny “good finance cannot be attained without intelligent care on the part of the citizens ... due equilibrium between income and outlay will only be found where responsibility is enforced by the public opinion of an active and enlightened community” Charles Bastable (1927) JIQ