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27-30 January 2003 Santiago de Chile XV Seminario Regional de Política Fiscal Daniele Franco The Debate on EMU Fiscal Rules OUTLINE a) EU fiscal rules b) Fiscal outcomes in 1992-2001 c) Criticisms of EU rules d) Challenges to EU fiscal policies European Monetary Union 1992: European Union countries decide to create a monetary union (Treaty of Maastricht) 1999: exchange rates of eleven countries irreversibly locked (Greece joins in 2001) 2002: euro coins and banknotes replace national currencies New development: many sovereign countries share a common currency and retain fiscal responsibility extensive implications for fiscal policy The need for EU fiscal rules Budgetary discipline widely recognised as essential condition for EMU success Fiscal rules considered necessary to: prevent moral hazard avoid externalities of deficits and debts avoid pressures on European Central Bank for ex-ante & ex-post bail-out Rules necessary also for contingent reasons: obtain radical changes in policies rapidly ensure credibility of EMU select EMU Member States The development of EU rules Gradual development of rules: 1992: Treaty of Maastricht set deficit (3%) and debt (60%) conditions for access to EMU, but left open issues 1997: Stability and Growth Pact (SGP) defined rules to accompany EMU on a permanent basis 1999: specification of operational aspects (e.g., target year for reaching balanced budget) Main aspects of EU rules 1) deficit should not exceed 3% of GDP unless exceptional events excess is temporary excess is limited 2) close-to-balance or surplus target over the cycle 3) multilateral surveillance (stability programs, notifications) 4) excessive deficit procedure (from recommendations to sanctions) 5) common statistical framework EU rules vs federal countries rules EU approach is stricter rules defined with reference to numerical parameters ex-ante and also ex-post compliance required non-compliance triggers predefined pecuniary sanctions flexibility margins defined ex-ante for exceptional factors no special provision for investment spending Multinational dimension requires formal & predefined solutions Why these rules? 1) Multinational context limited available solutions: cannot have implicit rules applying to many sovereign countries 2) Solutions influenced by contingent factors (i) problematic fiscal developments: high deficits and rising debts rising tax burden pro-cyclical policies need to obtain radical changes in policies need to rapidly ensure credibility of EMU (ii) need to select EMU members rules for selection applied in steady state EU rules vs Kopits-Symansky criteria Ideal fiscal rule EU fiscal rules Well-defined ++ Transparent ++ Simple +++ Flexible ++ Adequate relative to final goal ++ Enforceable + Consistent ++ Underpinned by structural reforms + EU rules vs Inman criteria Criteria Strong rule EU rules Timing for review Ex post Ex post Override by majority rule Not allowed Not allowed Enforcement Enforcer Access Penalties Independent Partisan Open Closed Large Large Amendment Process Difficult Difficult Fiscal outcomes up to 2000 EU rules successful up to 1998 (deficit declines: 6.4% 1.7%) 1999-2000: EU governments introduced tax cuts, without spending cuts (deficit about stable: 0.8% 0.7%) EU and US: similar deficit levels in early 1990s, but US improve budget balance faster and longer Fiscal consolidation: expenditure-based in EU, spending-and-tax-based in US 1993-2000 GP/GDP T/GDP USA -3.4% + 2.4% EU -4.7% +0.7% Fiscal outcomes 2000-2002 EU reaction to downturn milder than US: Budget balance: 2000 2002 EU: -0.7% -1.7% US: +1.5% -2.6% GP/GDP USA +1.7% EU +1.5% T/GDP -1.8% -0.5% Four EU countries close or above 3% deficit limit. - either avoid discretionary anti-cyclical policies / adopt pro-cyclical policies - or neglect rules loss of credibility New discussion on EU rules General Government: Balance (Surplus (+), Deficit (-)) Net of UMTS proceeds (% of GDP) 2 1 0 -1 -2 -3 -4 -5 -6 -7 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USA EU15 Euro12 General Government: Structural Primary Balance (Surplus (+), Deficit(-)) Net of UMTS proceeds (% of GDP) 5 4 3 2 1 0 -1 -2 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USA EU15 Euro12 General Government: Consolidated Gross Debt (% of GDP) 80 75 70 65 60 55 50 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 Euro-12 EU-15 USA Conflicting views "The stability pact is a vote of no confidence by the European authorities in the strength of the democratic institutions in the member countries. It is quite surprising that EU-countries have allowed this to happen, and that they have agreed to be subjected to control by European institutions that even the IMF does not impose on banana republics.” Paul de Grauwe, Financial Times, 25 July 2002 "Of course, the stability pact restricts the room for manoeuvre enjoyed by national fiscal policymakers. But this is the price that must be paid for a common currency. Historically, stability between currencies has been possible only when countries have been prepared to relinquish some national sovereignty.” H. Siebert, Financial Times, 6 Aug. 2002 Criticisms 1: There is no need for fiscal rules Rules lead to sub-optimal solutions. Better rely on discretionary decisions Either rely on wise governments or on effective financial markets High deficit high interest rates pressure on government consolidation but: (i) sufficient information? (ii) timely reaction of markets? (iii) timely reaction of governments? a risky solution with 12 ( 25) sovereign countries Criticism 2: rules are necessary but there are better rules Core issue: What rules would we want if we could start again from scratch? Are there rules clearly more intelligent than the SGP? Critical aspects of EU fiscal rules: reduce budgetary flexibility work asymmetrically disregard aggregate fiscal stance discourage public investment focus on short term commitments and disregard structural reforms too demanding for countries in sound positions Fiscal stabilisation EU rules designed to combine a sound fiscal position (3% deficit limit) and budgetary flexibility in recessions (structural balanced budget) Deficit fluctuates over cycle (automatic stabilisers can operate - contrary to past EU experience) But: (i) problems in the initial transition to balanced structural budget (ii) asymmetric structure of incentives: sanctions for deficits 3% but no incentive to avoid loosening in upswings Need policy-makers with medium or long-term views The EMU Fiscal Framework: A Stylisation SURPLUS 0 3% DEFICIT UNFAVOURABLE CYCLE LENGTH FAVOURABLE Fiscal co-ordination No explicit co-ordination procedure. Implicit rule-based co-ordination: let stabilisers work over the cycle In some circumstances aggregation of national fiscal policies may not result in optimal area fiscal stance - free-riding in stabilisation in bad times? - pro-cyclical policies in good times? However, supranational co-ordination would be problematic: - different cycles & policy views - forecasting & timing problems - enforceability of decisions Does the EU need a federal budget? Public investment Balanced budget tax-finance for public investment Risk: reduction of capital accumulation Transition period problematic: pay for new investment and pay back debt Exclude public investments from deficit rule (golden rule or dual budget)? but: • what is capital spending? • bias in favour of physical capital • contrasting evidence on effects of public investments on growth • multilateral surveillance more complex (e.g., evaluation of depreciation) • bigger role of private sector in infrastructure development Long-term fiscal sustainability no reference to long-term indicators in EU rules. Outcomes are assessed on a yearly basis this can discourage some tax and pension reforms (PAYG funding) involving a temporary deficit but the use of sustainability indicators (e.g., projections, generational accounting) would be problematic (e.g., comparability) moreover, balanced budget forces reforms and determines fast debt reduction Alternatives to the SGP? 1) fiscal co-ordination at EU level 1a) one EU fiscal policy 1b) co-ordination of national policies 1c) a market for deficit permits 2) fiscal institutions and procedures 2a) national budgetary procedures 2b) institutional reform (Fiscal Policy Committee) 3) different numerical rules 3a) golden rule 3b) expenditure rule 3c) permanent balance rule 3d) debt sustainability pact EU rules: a preliminary conclusion - 1 EU without rules: new experiment. Will have to rely on financial market discipline. Leap in the dark? Greater EU integration would allow more flexibility, but unlikely in mediumterm EU rules related to traditional solutions: balanced budget with exception for cyclical and exceptional events (but not for investment) EU rules present some problems, but no alternative solutions clearly superior Rules-based co-ordination necessarily somewhat inflexible (implicit mistrust of other countries’ behaviour) EU rules: a preliminary conclusion - 2 EU enlargement: if current EU members do not respect rules, can EU ask new members to do so? Radical changes of rules are very difficult (need unanimity). Risk: revisions can reduce credibility Can EU rules survive the current slowdown? If not, can monetary union survive (with up to 25 countries)? If rules survive, there is room for improvement: country differentiation, procyclical bias in good times, transparency Rules can be effective and not harmful only if governments endorse their spirit and are prepared to make efforts Are fiscal rules the problem? the debate on EU rules may divert attention away from more relevant issues: EU economic performance is unsatisfactory in terms of growth, activity and employment rates EU USA GDP growth rate 1985-1990 1991-2000 3.2 2.1 3.4 3.3 Unemployment rate 1991 2000 8.1 8.1 6.8 4.0 Labour market participation rate 2000 69 78 Fiscal challenges EU large public sectors and high tax burdens induce distortions & inflexibility economic integration increase tax competition and revenue losses reduces greater burden on less mobile bases inequity, distortions the ageing process increases spending: EU12 2000 18.0% 2050 24.5% USA 11.2% 16.7% need for structural reforms a tight budget constraint may increase the pressure to introduce expenditure reforms and accelerate debt reduction Average effective tax rates on labour 36 32 28 24 20 16 1970 1980 1990 USA EU-15 2000 Pensions Expenditure (% of GDP) 14 12 10 8 6 4 2000 2010 2020 EU15 2030 USA 2040 2050 Fiscal co-ordination - 1 1a) Move to single EU fiscal policy one money one fiscal policy Solve flexibility and fiscal stance problems but: are we ready for a federal country? 1b) Co-ordinate aggregate fiscal stance Have an aggregate stability programme: 3% limit applies to area deficit (or can even scrap limit). Political allocation of deficit permits Solve flexibility and fiscal stance problems but: national sovereignty problem different cycles & policy views conflicts in allocation of deficits forecasting & timing problems Fiscal co-ordination - 2 1c) A market for deficit permits Set total volume of deficit permits & let countries trade (A. Casella - drawing from markets for pollution rights) Solve flexibility & aggregation problems but: • initial allotment of rights? • small number of traders • different countries different externalities • who can predict cycle and set amount of rights? Fiscal institutions and procedures - 1 2a) Reform national budget procedures Introduce institutions and procedures conducive to responsible fiscal policy attack deficit bias at roots e.g. rules about presentation, adoption and execution of budgets. “Hierarchical” procedures more conducive to fiscal discipline than “collegial” procedures. But: • full agreement on solutions? • national sovereignty problem • reforms difficult to monitor • what if (apparently) correct solutions do not deliver results? • need time for testing Fiscal institutions and procedures - 2 2b) Introduce Fiscal Policy Committee Assign to FPC (accountable to Parliament) management of stabilisation policies on the basis of predefined mandate and judgement FPC responsible for setting the budget balance within debt sustainability constraint defined over a number of years FPC expected to deliver both long-term sustainability and short-term stabilisation Problems: (i) difficult to separate stabilisation from allocation & distribution (ii) government interference (appointments) (iii) need time for testing Numerical fiscal rules - 1 Given multinational context and need for rapid results permanent numerical constraints on domestic fiscal policy in terms of indicator of overall fiscal performance • simpler to evaluate compliance • easier to grasp by public opinion and policy-makers • solution based on long debate on budgetary rules What rule? golden rule, expenditure rule, debt rule Numerical fiscal rules - 2 3a) Exclude public investments from budget balance (golden rule) Solution adopted in some countries and decentralised governments Dual budget (current & capital): old issue (Musgrave, 1939) long debated (Sweden) Main pro: • spreading cost of durables over time (analogy to private sector finance) But: • what is capital spending? (opportunistic behaviour) • bias in favour of physical capital • unlimited borrowing low attention for projects Numerical fiscal rules - 3 Moreover, • dual budget discussed but little used • contrasting evidence on effects of public investments on growth • bigger role of private sector in infrastructure development • multilateral surveillance more complex (e.g., evaluation of depreciation) • in developed countries small net investment (Germany 1980-1999 = 0.6%) Numerical fiscal rules - 4 3b) Expenditure rule Introduce comprehensive expenditure target (all primary items; central & local) Solution adopted in some countries Benefits: spending can be controlled by government; monitoring easier; medium term framework But problematic in multinational context: • cannot have uniform EU rule, must rely on countries’ programmes • cannot commit future governments • deficit & debt may increase because of tax cuts Numerical fiscal rules - 5 3c) Permanent Balance Rule Buiter & Grafe (2002): PBR would ensure sustainability while considering country differences Permanent budget in balance or in surplus = difference of future values of tax revenue and spending (strong form of tax smoothing: tax rates constant with G depending on cycle, interest tates, structural factors) Implementation problems: estimates of permanent value of tax and spending take into account future preferences Numerical fiscal rules - 6 3d) Debt Sustainability Pact Pisani-Ferry (2002): countries (i) with debts 50% and (ii) publishing comprehensive fiscal accounts can opt out of EDP and embrace a DSP Countries indicate five-year target for debt ratio & have greater flexibility in short term • Avoid excessive tightening on sound countries. But can we fully overlook the deficit level? • Better fiscal accounting would provide more discipline by the financial markets. Estimate of future liabilities problematic: uncertainty related to macroeconomic, demographic and behavioural scenarios General Government: Total Outlays (% of GDP) 50 45 40 35 30 25 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USA EU15 Euro12 General Government: Current Tax and Non-Tax Receipt (% of GDP) 50 45 40 35 30 25 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USA EU15 Euro12 Old-age dependency ratios 2000-2050 (baseline scenario) 65% Year 2050 Year 2025 60% Year 2000 55% 50% 45% 40% 35% 30% 25% 20% EU UK S FIN P A NL L I IRL F E Gr D Dk B 15% Average effective tax rates on consumption 22 20 18 16 14 12 10 1970 1980 USA 1990 EU-15 2000 Average effective tax rates on capital 28 26 24 22 20 18 1970 1980 USA 1990 EU-15 2000 DIFFERENT MEDIUM TERM TARGETS Fix medium term targets also on the basis of debt level and future budgetary trends If debt and contingent liabilities are low: allow deficit up to minimal benchmarks This would allow funding of net investment without distortions and monitoring problems Need transparent fiscal accounting and accurate long-term projections IMPROVE TRANSPARENCY Transparency can increase credibility of rules and allow greater flexibility in implementation Current framework problematic: (i) oneoff measures, (ii) delays in data provision, (iii) limited data on off-budget liabilities (i) Publicise one-offs, lower danger threshold for early warnings, net one-off in computing structural balances (ii) Make greater use of cash data and debt (more timely and less subject to estimates). More independent statistical authorities (iii) Have regular and transparent estimates of off-budget liabilities, net asset positions & long term budgetary trends MISBEHAVIOUR IN GOOD TIMES Try to have some sanctions for slippages in good times and facilitate countries to behave prudently (i) Use early warning procedures in goods times when deficit diverge from structural target (ii) Allow the use of rainy-day funds: surplus in good times can increase room for manoeuvre in bad times Rainy-day funds require a change in ESA accounting: transfer should affect deficit (now they would be considered financial transactions) IMPLEMENTATION OF RULES Now enforcement is partisan: national authorities apply the rules to themselves. This may also reduce the incentive to behave well in good times Solution: give more responsibilities to the Commission - Commission responsible for technical assessment of compliance to the rules (excessive deficit) - Council decides what measures to require to countries in excessive deficit - Council decides sanctions on the basis of Commission recommendation 32 31 93 90 Total primary expenditure (% of GDP) 30 29 02 USA 28 00 27 26 29 30 31 32 33 45 93 44 43 EU-15 42 90 02 41 40 00 39 41 42 43 44 45 General government tax and non tax receipts (% of GDP) General Government: Structural Balance (Surplus(+), Deficit(-)) Net of UMTS proceeds (% of GDP) 2 1 0 -1 -2 -3 -4 -5 -6 -7 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 USA EU15 Euro12 The old debate on fiscal rules • Fiscal policy usually based on rules: either implicit (conventional wisdom) or explicit (laws) • Theoretical case for formal rules at national level: ambiguous results - counter deficit bias, transparency - induce distortions, lack of flexibility • Traditional solutions: budget balance with three main exceptions - capital expenditures - extraordinary finance - effects of the cycle budget balance over business cycle full employment balance functional finance Total primary expenditure (% of GDP) 32 31 93 90 30 29 02 USA 28 00 27 26 29 30 31 32 General government current tax and non tax receipts (% of GDP) 33 (% of GDP) Total primary expenditure 45 93 44 43 EU-15 42 90 02 41 00 40 39 41 42 43 44 General government current tax and non tax receipts (% of GDP) 45 A comparison EU USA GDP growth rate 1985-1990 1991-2000 3.2 2.1 3.4 3.3 Unemployment rate 1991 2000 8.1 8.1 6.8 4.0 Labour market participation rate 2000 68 79 Budget balance 1996-2000 -2.0 -0.1 Rules vs discretion Debate reflects the old discussion on rules: • counter deficit bias & increase transparency • but induce distortions & lack of flexibility Conflicting views: "The stability pact is a vote of no confidence by the European authorities in the strength of the democratic institutions in the member countries.” Paul de Grauwe, Financial Times, 25 July 2002 "Of course, the stability pact restricts the room for manoeuvre enjoyed by national fiscal policymakers. But this is the price that must be paid for a common currency.” H. Siebert, Financial Times, 6 Aug. 2002 Predominant view: monetary union without fiscal rules would be a risky experiment (a leap in the dark) Rules vs discretion Debate reflects the old discussion on rules: • counter deficit bias & increase transparency • but induce distortions & lack of flexibility Conflicting views: "The stability pact is a vote of no confidence by the European authorities in the strength of the democratic institutions in the member countries.” Paul de Grauwe, Financial Times, 25 July 2002 "Of course, the stability pact restricts the room for manoeuvre enjoyed by national fiscal policymakers. But this is the price that must be paid for a common currency.” H. Siebert, Financial Times, 6 Aug. 2002 Predominant view: monetary union without fiscal rules would be a risky experiment (a leap in the dark) • EU rules aim at combining a sound stabilisation fiscal Fiscal stance (3% limit) with budgetary flexibility in recessions (structural balanced budget) Deficit fluctuates over cycle (automatic stabilisers can operate) The asymmetric structure of incentives is quite problematic in this regard. It has been widely recognised that, ideally, the SGP should be complemented by fiscal policy guidelines encouraging EMU members to avoid fiscal laxity in periods of upswing and buoyant activity SURPLUS 0 3% DEFICIT BAD TIMES GOOD TIMES LENGTH OF CYCLE EARLY LESSONS One-off measures and new accounting and financial operations extensively used to meet targets EMU FRAMEWORK SUCCESSFUL IN REDUCING DEFICIT AND DEBT 3% PERCEIVED AS “HARD CEILING” GRADUAL CONVERGENCE TO CLOSE-TO-BALANCE BUT: IN 2000 NO PROGRESS IN STRUCTURAL TERMS PROGRAMMES FOR 2001: IMPROVEMENTS DUE TO CYCLE AND INTEREST PAYMENTS SLOWDOWN IN GDP: TARGETS THE COMPOSITION OF FISCAL ADJUSTMENT EMU RULES DO NOT CONSIDER COMPOSITION OF FISCAL ADJUSTMENT SIZE OF GOVERNMENT SUBSIDIARITY REASONS SEVERAL STUDIES: ROLE OF COMPOSITION OF ADJUSTMENT (SUSTAINABILITY, ETC) EURO-AREA: 1992-1993: REVENUE BASED 1994-1997: EXPENDITURE BASED 1998-2004: EXPENDITURE BASED (CONSOLIDATION + TAX CUTS) LONG-TERM SUSTAINABILITY - 2 CHALLENGE OF AGEING : PENSION EXPEND.: 3 to 5 % OF GDP TOTAL EXPENDIT.: 5 to 8 % OF GDP CAN CURRENT REVENUE LEVELS BE MAINTAINED IN AN INTEGRATED ECONOMY? BUT FAST DEBT REDUCTION OFFSETS PRESSURES OF AGEING INCREASING ROLE OF LONG-TERM ISSUES IN EU SURVEILLANCE: RECOMMENDATIONS, PROJECTIONS FISCAL RULES -1 Conventional wisdom against borrowing: “And thou shalt lend unto many nations, but thou shalt not borrow” - Deuteronomy “The budget should be balanced, the treasury should be refilled, public debt should be reduced ...” - Cicero “Our modern expedient is to mortgage the public revenues … a practice which appears ruinous” - David Hume FISCAL RULES -2 For a long time the orthodox view of economists reflected such common wisdom: “What is prudence in the conduct of every private family, can scarcely be folly in that of a great kingdom” - Smith borrowing allows governments “… to conceive gigantic projects that lead sometimes to disgrace, sometimes to glory, but always to a state of financial exhaustion” - Say debt is “… one of the most terrible scourges which was ever invented to afflict a nation, … a system which tends to make us less thrifty, to blind us to our real situation” - Ricardo FISCAL DISCIPLINE AND FLEXIBILITY Fiscal stabilisation recognised as a fundamental function: area cycles & asymmetric shocks deficit ceiling + close-to-balance target balance fluctuates over the cycle: stabilisers can operate freely Problems: transition to close to balance fiscal policy in good times (lack of sticks and carrots) lack of consensus on estimation of cyclically adjusted balances TECHNICAL CRITICISMS - 1 SGP reduces budgetary flexibility it may require pro-cyclical policies or may prevent discretionary action (i) true in transition (ii) unlikely in steady state: safety margins sufficient to cope with most recessions + exceptionality clause SGP disregards aggregate fiscal stance aggregation of national fiscal policies may not result in optimal area fiscal stance possible, but - if stabilisers work, no problem in most cases - coordination of national policies problematic - close-to-balance better than past situations, when high deficit constrained policies TECHNICAL CRITICISMS - 2 SGP discourages public investment no longer be possible to spread the cost of an investment project over all the generations of taxpayers who benefit from it true, but - GR problematic: distortions, monitoring - net investment not big in several countries SGP focuses on short term commitments and disregards structural reforms true, but - long term indicators operationally problematic - close to balance debt ageing TECHNICAL CRITICISMS - 3 SGP works asymmetrically does not curb incentives to cut revenue or increase expenditure in good times true: need peer pressure, long-term views SGP does not sanction politicallymotivated fiscal policies unlike 1997 convergence, sticking to rules do not pay politically true: need peer pressure, long-term views SGP too demanding for countries in sound positions SGP treats equally countries with different long-term prospects and debt levels true Fiscal outcomes EU rules successful up to 1997 (Deficit declines: 6% 2.5%) Balanced budgets targeted for 2002 But, once monetary union was started, governments introduced tax cuts (without spending cuts) 2002: four countries constrained by the 3% deficit limit. Either - avoid discretionary anti-cyclical policies or adopt pro-cyclical policies - or neglect rules (loss of credibility) New discussion on rules Criticisms 2: EU rules now hamper stabilisation policies Short-term approach But solutions to current policy dilemma depend on views about SGP in steady state: - if rules are unnecessary or SGP inferior to other solutions, why bother? - if rules necessary and no solution clearly superior to SGP, better retain it and bear some adjustment costs Critical views of EU rules - 1 Three main arguments: There is no need for fiscal rules. Rules lead to sub-optimal solutions. Better rely on discretionary ad hoc decisions EU rules may be fine in principle, but they are now an obstacle to adequate stabilisation policies Rules are necessary, but we could have more intelligent rules than the EU rules