2  Fiscal rules - theory and international experience

Definitions and objectives of fiscal rules

Fiscal rules are a type of fiscal institution - the arrangements that form a nation's public finance framework. Institutions include the legislative framework for budgeting and fiscal planning, any policy guidelines or well-established norms, the public agencies involved in the planning and implementation of the budget process, and any independent entities that give advice or monitor performance.

Kopits and Symansky (1998) define a fiscal rule as “a permanent constraint on fiscal policy through simple numerical limits on budgetary aggregates”. Although the legal form can vary - international treaty, constitutional amendment, legal provision, or policy guideline - a common theme, as the International Monetary Fund (IMF, 2009) has noted, is that fiscal rules are all mechanisms aimed at supporting fiscal credibility and discipline. Ongoing debate over the relative merits of rules versus the merits of other institutions, such as a fiscal policy committee or a fiscal advisory council, is outside the scope of this paper.[1]

Fiscal rules can have various objectives, such as promoting debt sustainability, promoting macroeconomic stabilisation, containing the size of government, or supporting intergenerational equity. The key objective is usually the promotionof fiscal sustainability. The IMF (2009) has compiled a dataset of fiscal rules applied to central government in member countries, and characterised the rules into the following groupings:

• budget balance rules - including rules that relate to the overall balance, the structural or cyclically-adjusted balance, or the balance over the cycle, with the aim of restraining the build-up of debt-to-GDP ratios;
• debt rules - such as a limit or target for public debt as a share of GDP;
• expenditure rules - also known as spending rules, may involve limits on total, primary or current spending, either in absolute terms, growth rates or as a share of GDP; and
• revenue rules - may be ceilings to prevent an excessive tax burden, or floors aimed to boost revenue.

Prevalence of fiscal rules

Fiscal rules have become more prevalent among countries over the past two decades. The IMF (2009) has documented a rise in the use of fiscal rules; in 1990, only seven countries had national or supranational fiscal rules applying to central government, whereas by 2009 this had increased to 80 countries. This increased attention to fiscal rules was, at least in part, a reaction to a build-up of public debt in many countries through the 1970s and 1980s.

In recent years, spending rules, themselves a subset of fiscal rules, have become more widespread, reflecting a trend for countries to move from a single rule - such as a debt or a balanced budget rule - to multiple rules. The choices and tradeoffs involved in a wider set of rules are discussed by Anderson and Minarik (2006) and Kumar and Ter-Minassian (2007). In 2009, 25 countries were making use of spending rules in some form - whereas only ten countries had been using a spending rule in 1999 (IMF, 2009). The increased prevalence of spending rules, in particular, reflects the fact that a debt target or balanced budget rule, on its own, places little discipline on the growth in government spending in the times of strong revenue growth during an economic expansion (Barker and Philip, 2007).

Design features

The IMF (2009) has suggested that there are three components of effective fiscal policy rules:

1. an unambiguous and stable link between the numerical target and the fiscal objective;
2. sufficient flexibility to respond to shocks, so that a rule should at least not exacerbate the macroeconomic impact of a shock; and
3. a clear institutional mechanism to map deviations from the rule into incentives to take corrective actions (e.g. by raising the cost of deviations, or mandating the correction of a deviation).

The legal form of fiscal rules may vary. With regard to spending rules, although in some (predominantly developing) countries these are embedded in national legislation, the IMF has found this is not necessarily a requirement for a rule to endure. Ljungman (2009) examines spending rules in three countries - Finland, the Netherlands, and Sweden - and found that each has the status of a political commitment with no predefined sanctions in the event of a breach, other than reputational costs for the Government. Ljungman concludes that any spending rule that is not perceived as serving the interest of the Government and Parliament will inevitably be circumvented, and that “in the absence of this widespread political support, it is doubtful that the legislative status of a spending rule will have any impact on actual policy formulation”.

Effectiveness of fiscal rules

Research into the effectiveness of fiscal rules is ongoing, but in reviewing available empirical studies the IMF has concluded that fiscal rules have generally been associated with improved fiscal performance (IMF, 2009). In addition, Badinger (2009) has found tentative evidence across a sample of OECD countries that the fiscal rules introduced since 1990 reduced the extent to which governments have made use of discretionary fiscal policy, although no New Zealand-specific results are reported. Intuitively, the effectiveness of a rule depends on the institutional context into which the fiscal rule is being applied and the macroeconomic environment, as well as the design of the rule itself.

In terms of spending rules, countries such as Finland, the Netherlands, and Sweden, appear to have had positive experiences. Ljungman concluded that the general impression in each of those countries has been that a spending rule has contributed to maintaining stable public finances. However, as Ljungman notes, an unambiguous correlation between the spending rules and the robustness of public finances is difficult to establish, particularly since economic growth had been relatively strong in the period between their introduction in the mid-1990s and the time of his review in 2008. In addition, Finland and the Netherlands are part of the euro area, so it is plausible that improvements in the conduct of their fiscal policy have been influenced by requirements of the Stability and Growth Pact associated with that monetary union.

The global financial crisis in 2008/09 and the associated macroeconomic shocks have posed challenges for fiscal institutions in many countries. There are signs that even countries with established spending rules have substantially increased spending in an environment with lower-than-expected economic growth and decisions to implement fiscal stimulus packages. For example, the OECD's Economic Outlook from May 2010 forecast general government spending as a share of GDP to have increased between 2007 and 2011 in Finland (+8.2 percentage points), the Netherlands (+6.4 percentage points) and Sweden (+2.8 percentage points).[2] It will be interesting to see how countries with spending rules fare in managing spending growth over the next few years.