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The experience of the European Union countries suggests that a debt-to-GDP ratio in excess of 60% is not sustainable. The U.S. has emerged as a major debtor nation, with a debt-to-GDP ratio well above this sustainable level. The debt target for the U.S. should be a debt-to-GDP ratio below this sustainable level, and fiscal rules should be designed to achieve that debt target.

Experience with fiscal rules in OECD countries identifies several characteristics of successful fiscal rules. A combination of fiscal rules has proven to be the most effective way to achieve debt targets. In high debtor countries, such as the U.S., the fiscal rules should provide for a transition from current debt levels to a target debt level. The fiscal rules should achieve this objective, consistent with macroeconomic stabilization and economic growth.

Countries attempting to limit the size of government often rely on expenditures and/or revenue rules capping the level or rate of growth in expenditures and/or revenue. Some rules are designed to impose a constraint on fiscal policy while providing for flexibility in spending over the business cycle. Cyclically adjusted or structural balance rules allow for deficits and surpluses over the business cycle while reducing deficits and the accumulation of debt in the long term.

Fiscal rules designed to achieve debt targets will impose limits on discretionary fiscal policy. There is likely to be a tradeoff in designing rules to constraint fiscal policy, and using fiscal policy for macroeconomic stabilization. Greater flexibility in using fiscal policy for macroeconomic stabilization may weaken the effectiveness of fiscal rules in achieving debt targets.

OECD countries are also experiencing a demographic shock that has important implications in designing fiscal rules. An aging population combined with more generous benefit programs for pension and health care benefits is creating a perfect storm. The unfunded liabilities accumulating in retiree pension and health care plans is pushing the debt-to-GDP ratio close to the debt limit in many countries. Fiscal rules must be flexible in responding to these long term demands for government services. However, in many countries, including the U.S., reform of these pension and health care plans is a prerequisite to achieving a sustainable fiscal policy.

Countries often rely on a combination of fiscal rules to achieve multiple objectives. For example, Sweden relies on all of these rules to achieve both near-term and long-term objectives. A cyclically balanced budget rule is designed to eliminate deficits over the business cycle. Sweden set a target to reduce debt/GDP in the near term in order to provide greater flexibility in meeting retiree pension and health care needs in the long term. These targets are then translated into an expenditures limit imposed over a three-year budget cycle.

The different fiscal rules are part of a broader fiscal framework governing fiscal policy in these countries (Kumar et. al., 2009; Schaechter et al, 2012). The effectiveness of fiscal rules depends upon the institutional arrangements for implementing and enforcing the rules. Some countries have strict accounting and monitoring of fiscal rules through fiscal responsibility laws. A few countries, such as Sweden, have established independent agencies responsible for implementing and enforcing the rules.

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Summary Designing a Fiscal Framework

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