Rules to contain lavish government deficits are most effective if countries design them to be simple, flexible, and enforceable in the face of changing economic circumstances.
In new analysis, we look at fiscal rules in over 90 countries and, based on their experiences, find that the rules put in the place over the last three decades often were too complex, overly rigid, and difficult to enforce.
Fiscal rules set the course for a government’s responsible fiscal policy. For example, a government can decide to limit its annual borrowing to 3 percent of the economy’s total income, as is the case in many European countries. Rules can help prioritize among the many demands on the budget, chart a predictable path for government policy, and keep public debt in safe territory.
The analysis shows that better-designed rules can help avoid excessive deficits, which hinder sustainable public finances. This reassures financial markets and investors, and, as a result, countries that comply with their fiscal rules can borrow more cheaply. Countries with excessive deficits and lax rules have higher borrowing costs because investors see them as more of a risk.
By demonstrating a government’s commitment to well-managed public finances, fiscal rules can create room in the budget to finance policies that promote growth, enhance the economy’s resilience to adverse shocks, and reduce excessive income inequality.
Past as prologue: lessons for rule design
Some key features have proved to enhance the rules’ effectiveness in the past:
- Broad coverage, meaning that the rule should cover most, if not all of the budget, reducing possible loopholes.
- A design that encourages countries to save money in good economic times, for instance by preventing large expenditure increases, which can absorb all revenue windfalls.
- Limits on fiscal aggregates that are based on sound economic principles. For instance, governments should not set the debt ceiling too high to foster fiscal responsibility. But the debt ceiling should not be too low either, to enable desirable policies, such as filling public infrastructure gaps or offsetting the economic impact of large shocks.
- Precise exceptions to let the budget accommodate unexpected events, like natural disasters.
Also, successful fiscal rules need political buy-in, as well as supporting institutions that enhance fiscal transparency and accountability—such as fiscal councils, which governments establish to act as public watch dogs to evaluate fiscal policy. Most European countries have, for instance, set up fiscal councils in recent years.
In the past decade, substantial reforms have led to a second-generation of rules. These are: first, more flexible, for example with new and better-defined exceptions; and second, easier to enforce, for example, by adding correction mechanisms that foresee what the government should do when they break the rule. Jamaica and Grenada have introduced correction mechanisms in 2014 and 2015.
However, we find that these innovations have made the rules more complicated to operate with no discernible impact on compliance yet.
Three principles for future reforms
To address these shortcomings, our analysis provides three principles to guide the design of new rules and the reform of old ones:
- Make sure that the package of rules is consistent, parsimonious, and guarantees debt sustainability. Fiscal rules should include both a debt rule to set the course of medium-term fiscal policy, and a small number of operational rules that guide annual budget decisions, such as an expenditure rule or a budget balance rule. Reforms should ensure that these rules are not redundant and do not send conflicting signals.
- Create incentives for better compliance with rules. We find that governments comply with their rules about half of the time. To encourage governments to follow the rules, compliance should bring more tangible benefits, and there should be stronger costs for noncompliers. Although financial sanctions are often not credible, recent efforts to raise reputation and political costs seem more promising, notably through the role of fiscal councils that monitor and expose to the public possible mismanagement of public funds.
- Allow for adequate flexibility without sacrificing simplicity too much . Rules that permit some deviations from targets in response to economic shocks, such as the budget balance rule, are often complicated and hard to implement. Expenditure rules may provide a better balance between flexibility and simplicity, as the chart below shows.
Of course, countries should tailor these three principles to their own circumstances.