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The starting point in designing a fiscal framework is to define fiscal targets and instruments. A debt target is the anchor that incorporates expectations about future fiscal policy and is the reference point in designing fiscal rules. Debt rules typically set a limit or target for debt in the medium term. The debt target may vary in the long term, such as when an aging population impacts spending for retiree pension and health benefits. A criterion used for fiscal solvency is reduction and convergence of debt to a level that ensures that the intertemporal budget constraint is met, even when the interest rate on public debt exceeds the rate of growth of GDP (Schaechter et al, 2012)

In recent decades fiscal rules have been imposed at both the national and supranational level to achieve debt targets in OECD countries. A fiscal rule can be defined as a permanent constraint on fiscal policy through simple numerical limits on budgetary aggregates (Kopits and Symansky, 1998). Fiscal rules are usually distinguished using a taxonomy (Kumar et. al., 2009; Schaechter et al, 2012):

A Taxonomy of Fiscal Rules

Budget Balance Rules

  • Annually Balanced Budget
  • Numerical Budget Target Deficit or Surplus
  • Structural Balance Target
  • Cyclical Balance

Revenue Rules

  • Targeting Nominal or Real Revenues
  • Targeting Nominal or Real Revenues as a Share of GDP
  • Targeting the Rate of Growth in Revenues

Expenditure Rules

  • Targeting Nominal or Real Expenditures
  • Targeting Nominal or Real Expenditures as a Share of GDP
  • Targeting the Rate of Growth in Expenditures

Debt Brake Rules

  • Targeting Nominal or Real Debt
  • Targeting Nominal or Real Debt as a Share of GDP
  • Targeting a Rate of Change in Debt

Deficit Brake Rules

  • Targeting Real or Nominal Deficit
  • Targeting Real or Nominal Deficit as a Share of GDP
  • Targeting a Rate of Change in Deficit

In designing a fiscal framework it is important to distinguish between countries that are pursuing sustainable fiscal policies and countries that are not (Ayuso Casals, A. 2012; Fall, F. and J-M.
Fournier 2015; Fall, F., et al. 2015). There is an extensive literature measuring the sustainability of fiscal policy. While economists may disagree on the different measures of sustainability, elected officials have arrived at a consensus measure. Both the OECD and the European Union have adopted the rule of thumb that a debt-to-GDP ratio in excess of 60% is not sustainable. These organizations also maintain that a country with a deficit-to-GDP ratio in excess of 3% is pursuing an unsustainable fiscal policy. These measures are then used as benchmarks in guiding fiscal policies toward sustainable levels of debt.

On the one hand we can identify a group of countries that have applied fiscal rules to achieve a sustainable fiscal policy (Merrifield, J., and B. Poulson. 2016a).. These countries are in an enviable position. They have the fiscal room to pursue discretionary fiscal policy, as well as automatic stabilizers to maintain macro-stability over the business cycle. A cyclically balanced budget with deficits offset by surpluses will allow them to maintain or reduce their debt-to-GDP ratio over time.

In countries that have not achieved fiscal sustainability, it is more difficult to design a fiscal framework, especially if they are close to their debt limit. These countries must adopt more stringent fiscal rules, and may not have the fiscal room to pursue discretionary fiscal policy. Even deficits incurred to finance the automatic stabilizes may pose a risk for these countries. These countries may need to impose stringent limits on expenditures that precludes deficit spending, even in periods of recession. They may need to target a budget surplus in the medium term in order to achieve a sustainable fiscal policy in the long term.

Designing a fiscal framework in highly indebted countries is especially difficult. Pursuing a countercyclical policy incurring deficits in periods of recession could push these countries toward a debt limit at which increased risk of default causes the risk premium and interest rate to spiral out of control. Highly indebted countries may have to forego discretionary fiscal policies and rely on the automatic stabilizers over the business cycle.

The focus of fiscal rules and fiscal policy in highly indebted countries should be on debt reduction, reducing the debt-to-GDP ratio toward a target below the sustainable level. For example, Greece and Italy are highly indebted countries that must reduce their debt-to-GDP ratio below 60% to conform to EU fiscal rules. They must impose stringent limits on expenditures and target a budget surplus in the medium term. Highly indebted countries that fail to impose this fiscal discipline, such as Argentina, may default on their debt.

It may be surprising to learn that the U.S. has emerged as a highly indebted country, with debt-to-GDP levels comparable to that for Italy and Greece (Merrifield, J., and B. Poulson. 2016b; Merrifield, J., and B. Poulson. 2017). Like other highly indebted countries, the U.S. is now close to the debt limit. If the U.S. were to pursue fiscal policies as it did during the recent financial crisis, incurring deficits that doubled the national debt, there is a high probability that these fiscal policies would be accompanied by sharp increases in the risk premium and interest rates on U.S. debt. It is not out of the realm of possibility that in a severe financial crisis the U.S. would have to suspend payments on its debt. Given these challenges, the U.S. must forego discretionary fiscal policy and rely only on the automatic stabilizers in another recession. To avoid default, the U.S. must now enact fiscal rules that impose stringent limits on government expenditures. Stringent limits on expenditures is a necessary condition for the U.S. to reduce the debt burden and achieve a sustainable fiscal policy

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The Objectives of a Fiscal Framework

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