Expenditure Rules Emerge as the Anchor of a Sound Public Financial Management System
The period since 1990 has witnessed a sharp increase in the number of fiscal rules at both the national and supranational level. Fiscal rules of course are not new to this modern era. Balanced budget rules date back to the early nineteenth century, and some three dozen countries have incorporated balanced budget provisions in their constitutions (Asatryan et al 2016). Balanced budget provisions were incorporated in the constitutions of all the states with the exception of Vermont (Merrifield and Poulson 2014). What is unique is not only the number of fiscal rules enacted in recent years, but also the innovation of new fiscal rules designed to complement balanced budget rules. They include deficit and debt rules, revenue rules, and expenditure rules. The constraints imposed by these rules are usually combined with procedural rules such as voting requirements for tax, expenditure, and other fiscal measures.
In recent years, expenditure rules have been the focus of rules-based approaches to fiscal policy at both the national and supranational level (Ayuso I Casals, 2012; Debrun, 2015; IMF, 2014; Cordes et al. 2015). Expenditure rules have proven to be the most effective anchor for a sound public financial management (PFM) system. Expenditure rules are defined broadly to include both specific numerical targets fixed in legislation, and expenditure ceilings for which targets can be revised. The targets may be defined with reference to total expenditures, expenditures as a share of GDP, or the rate of growth in expenditures. The expenditure rules are often combined with other fiscal rules to achieve multiple objectives.
The most effective of the expenditure rules introduced in recent years have been spending caps targeted to achieve desired levels of deficits and debt. This combination of expenditure caps and deficit and debt rules was first introduced in Switzerland. The so called Swiss ‘debt brake’ was the model for similar expenditure rules enacted in other countries, and for the Fiscal Compact adopted by the European Union in 2012. The Compact mandated that when the deficit/GDP ratio exceeds a 3 percent tolerance level the countries are expected to reduce the rate of growth in expenditures; and when the debt/GDP ratio exceeds a 60 percent tolerance level they must also slow the rate of growth in spending. While the Fiscal Compact set a common fiscal framework, it was up to the individual European countries to enact fiscal rules consistent with the requirements of the Compact.
The Expenditures Cap
The most important choice that legislators must make for an effective fiscal rule is the expenditure cap. Because the U.S. faces a formidable task of fiscal consolidation, a stringent cap must be imposed on the growth in federal spending. From our experience in studying state fiscal stress, we found that there are basically two approaches in designing a spending cap. Most states impose a spending cap which is linked to personal income. Our analysis revealed that personal income growth is too volatile a basis for capping federal spending growth. Linking the spending cap to the sum of U.S. population growth plus inflation can achieve a more stable growth in federal expenditures.
Limiting the growth in federal expenditures to the sum of population growth and inflation would impose a more stringent cap on spending compared to one linked to personal income growth. The demand for government services may increase at a rate in excess of this spending cap. To give legislators the flexibility to adjust federal expenditures in response to the demand for those services, the spending cap allows federal spending to grow at a multiple of the sum of population growth plus inflation.
This design of the spending cap is especially important in planning for the long term growth in entitlement spending in the United States. Even with entitlement reform, these expenditures will increase with the growth in population and changes in the age composition of the population. Legislators could plan for this long-term increase in the demand for entitlement spending by imposing a more stringent spending cap in the near term and a less stringent cap in coming decades. For example, choosing a spending cap multiplier equal to unity would limit the growth in spending to the sum of population growth and inflation in the near term. In the long term, the spending cap multiplier could be adjusted upward to allow increased spending in response to increased demand for entitlement spending (see accompanying box which illustrates how the choice of a multiplier impacts the spending cap).
The spending cap multiplier should be adjusted in response to long-term changes in the demand for government services. The proposed MP rule has other design components to respond to short term changes in the demand for government services, such as increased expenditures for unemployment compensation and income transfers in periods of recession.