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“The debt trajectory is the core concern of the fiscal framework. Given the uncertainties surrounding the macroeconomic determinants of debt developments and also that these macroeconomic variables are beyond the control of the government, though they are endogenously affected by government policies, fiscal rules will target the main determinants of debt directly under government control.

Fiscal rules should have two objectives: (1) anchor fiscal policy expectations by targeting a prudent debt level and (2) allow for macroeconomic stabilization that enhances economic growth. Fiscal stimulus to mitigate recession increases uncertainties surrounding the debt path: there is a trade-off between these two objectives. Real time stimulus may stabilize the cycle, but also affects debt dynamics (Fall et al. 2015 p.35).”

“A good fiscal rule should have two main properties. The fiscal rules should define a confidence interval or a band for its main variables to accommodate macroeconomic fluctuations. If the economy has a budget or structural deficit close to a fixed limit, the limit constitutes an important restriction for the stabilization effects of both the automatic stabilizers and counter-cyclical discretionary fiscal policy in a downturn.

A combination of rules should ensure compliance with the chosen debt trajectory. A budgetary constraint cannot only refer to the budget balance, if it is to avoid potential adverse effects on the underlying components of the budget balance (e.g. undesirable tax increases to compensate for structural problems on the expenditure side) (Fall et al. 2015 p.36).”

The rules differ in their ability to fulfil objectives of reaching a prudent debt target and of stabilization. The structural budget balance rule combines, in principle, the capacity of satisfying the two objectives, but it has important drawbacks in terms of observability and real time assessment. Structural balance measures, despite some progress on measurement, are highly dependent on volatile and often biased estimates of the output gap and subject to frequent revisions (Hers and Suyker, 2014). For instance, for Slovakia, Klein et al. (2013) report that the structural deficit in 2010 using pre-crisis estimates of potential growth would have been nearer to 4% than 8% of GDP.

Also, structural deficits can be revised sharply in the case of a crisis as potential growth is not well measured in real time. In particular, the downward revision of the structural primary balance was about 7% of GDP for Greece and about 3% of GDP in Ireland. These revisions follow growth surprises: on average across countries, a 1% real output shock is associated with a 0.2% revision of the potential output level (Fall and Fournier, 2015 p.36).

Therefore, the adoption of a budget balance rule complemented by an expenditure rule could suit most countries well, the combination of the two rules responds to the two objectives. A budget balance rule encourages hitting the debt target. And, well-designed expenditure rules appear decisive in ensuring the effectiveness of a budget balance rule (Guichard et al., 2007). Carnot (2014) shows also that a binding spending rule can promote fiscal discipline while allowing for stabilization policies. The marginal benefit of adding a revenue rule is likely outweighed by its costs in terms of complexity and reduction in fiscal flexibility (Fall et al. 2015 p.37).”

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What is the Optimum Combination of Fiscal Rules?

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