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Important innovations in fiscal rules that have been used successfully in a number of OECD countries are debt brakes and deficit brakes (Merrifield and Poulson 2016, 2017). . One can think of these as trigger mechanisms that automatically adjust the spending limit.

A debt brake is used in the EU countries to signal when a country has exceeded the debt-to GDP level considered sustainable. When the debt-to-GDP level exceeds 60% the country must enact fiscal reforms designed to reduce the debt –to- GDP ratio to a level considered sustainable.

A debt brake can be designed to be triggered automatically, preventing the country from accumulating unsustainable debt. The debt brake could be triggered as the debt-to GDP ratio begins to exceed a sustainable level. For example, if 60% is a sustainable level, then the debt brake could be triggered when the debt-to-GDP level reaches 80% of that level, i.e. 48%. At that point an expenditure limit would be imposed designed to eliminate deficits and/or generate surpluses. A multiplier could be used to impose a more stringent expenditure limit as the debt-to-GDP ratio approaches 60%.

A deficit brake is also used by the EU countries to signal when deficit spending exceeds what is considered a sustainable level. When the deficit-to-GDP level exceeds 3% the country must enact fiscal reforms to reduce the deficit-to-GDP ratio to a level considered sustainable.

A deficit brake can also be designed to be triggered automatically, preventing the country from incurring unsustainable deficits. For example, if 3% is considered a sustainable level, then the deficit brake could be triggered when the deficit-to-GDP ratio reaches 80% of that level, i.e. 2.4%. At that point an expenditure limit would be imposed designed to reduce the deficits or incur surplus revenue. A multiplier could be used to impose a more stringent expenditure limit as the deficit-to-GDP ratio approaches the 3% level.

Each country has a unique set of fiscal institutions that will determine the impact of any set of fiscal rules. Dynamic simulation models are used to estimate the relevant parameters for a country, and to estimate the potential impact of fiscal rules. For a dynamic simulation analysis of the potential impact of debt brakes and deficit brakes in the U.S. see Merrifield and Poulson (2016, 2017).

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Debt and Deficit Brakes

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