Number 275 - April 2007 The role of fiscal rules and institutions in shaping budgetary outcomes Proceedings from the ECFIN Workshop held in Brussels on 24 November 2006 Edited by J. Ayuso-i-Casals, S. Deroose, E. Flores and L. Moulin (Directorate-General for Economic and Financial Affairs) Economic Papers are written by the Staff of the Directorate-General for Economic and Financial Affairs, or by experts working in association with them. The “Papers” are intended to increase awareness of the technical work being done by the staff and to seek comments and suggestions for further analyses. Views expressed represent exclusively the positions of the author and do not necessarily correspond to those of the European Commission. Comments and enquiries should be addressed to the: European Commission Directorate-General for Economic and Financial Affairs Publications BU1 - B - 1049 Brussels, Belgium ECFIN.C2/REP/2104 ISSN 1725-3187 (online) ©European Communities, 2007 THE ROLE OF FISCAL RULES AND INSTITUTIONS IN SHAPING BUGETARY OUTCOMES Workshop organised by the European Commission Directorate General for Economic and Financial Affairs Brussels, 24 November 2006 Edited by J. Ayuso-i-Casals, S. Deroose, E. Flores and L. Moulin (Directorate General for Economic and Financial Affairs) Preface Economic literature has provided abundant analysis on how taxes, government expenditures and government balance should be set over the business cycle for fiscal policy to be considered optimal and sustainable. However, experience also presents ample evidence that such policies were in practice not always pursued by policymakers. This has notably been reflected in the propensity to finance public expenditure with debt and to conduct pro-cyclical policies, and in difficulties to restructure public expenditure (i.e. quality aspects of public finances). Such developments have drawn the attention from policy analysts and academics, who have been exploring the reasons for the existence of a deficit bias. The explanations generally point to the consideration that policy makers may not have the right incentives to pursue sound public finances in the long run. Literature has notably stressed that adequate institutional settings at national level can play an important role in containing spending and deficit biases. These settings include in particular: (1) procedural rules of the budgetary processes, i.e. the process laid down in law or constitution governing the elaboration of the annual budget law; (2) numerical fiscal rules which are guiding or imposing constraints on the discretion of policy-makers; and (3) independent institutions in charge of providing inputs (forecasts, analysis) and formulating recommendations in the area of fiscal policy. In the context of the discussions on the 2005 reform of the SGP, the Council has also emphasized the importance of developing and strengthening fiscal governance in the EU Member States. The Council stated that national budgetary rules should be complementary to the Member States’ commitments under the Stability and Growth Pact. The Council also underlined that domestic governance arrangements should complement the EU framework, and that national institutions could play a more prominent role in budgetary surveillance to strengthen national ownership, enhance enforcement through national public opinion and complement the economic and policy analysis at EU level. Most of the Member States have developed national fiscal frameworks in order to improve fiscal policy making and outcomes. Better knowledge on their design, main features and implementation is crucial to contribute to the improvement of the effectiveness of fiscal governance. The workshop "The role of national fiscal rules and institutions in shaping budgetary outcomes" organized by the Directorate-General for Economic and Financial Affairs (DG ECFIN) of the European Commission on 24 November 2006 in Brussels aimed at enriching the debate on these fiscal arrangements and improving the understanding of their functioning. This Economic Paper of DG ECFIN contains all the paper presented in this event that was organised in four sessions (see programme in next page). A first set of papers mainly focus on the impact of numerical fiscal rules on budgetary outturns. The paper by Ayuso, González, Moulin and Turrini, which is based on a comprehensive data base on the existing national fiscal rules in EU countries built up by DG Ecfin, finds a beneficial effect of fiscal rules on fiscal developments (i.e. lower deficits or higher surpluses, more moderate growth of public expenditure, and fewer pro-cyclical fiscal policy episodes). In the same vein, Broesens and Wierts show that a sound fiscal institutional setting, including strong expenditure rules, is one of the factors that can explain the positive budgetary results achieved by some countries. By contrast, the presentation by Debrun and Kumar raises the issue of reverse causality between fiscal rules and budgetary outturns, and argue that fiscal rules may however constitute useful devices to signal politic commitment to fiscal discipline. Other papers deal primarily with the appropriate design of fiscal rules and institutions. Thus, according to Krogstrup and Wyplosz the optimal deficit or debt ceiling is likely to be time-varying whereas the setting of such ceiling may be delegated to a non-partisan independent fiscal agency. Hallerberg and Stéclbout-Orseau discuss under what conditions independent budgetary bodies may influence fiscal policy making, and argue that 'fiscal watchdogs" should be implemented at national level in order to be more effective. Finally, the paper by Kirsanova, Leith and Wren-Lewis puts forward a proposal for the establishment of a fiscal agency to monitor debt developments. An additional group of papers addresses the relationship between the fiscal governance approach adopted by the EU Member States and their institutional and political frameworks. The importance of the political and electoral system to implement either the so-called "delegation" or "contract" approach to centralise budgetary procedures, and the apparent difficulties of "delegation" States to adhere to the SGP provisions are the main message of the paper presented by Hallerberg, Strauch, and von Hagen. These views are challenged by Hodson's presentation, who gives some evidence raising doubts on the supposed incompatibility between delegation Member States and a rules-based system for fiscal governance such as the SGP. Finally, the remaining presentations relate more directly to policy experiences. While the paper by Balassone, Franco and Zotteri evaluates the feasibility of implementing "rainy day" funds in the EU countries on the basis of the USA experiences, the paper by Boije and Fisher, and Lebrun assess the functioning of the existing set of fiscal rules in Sweden and Fiscal Councils in Belgium respectively. Overall, the majority of papers presented in the workshop, which consider fiscal rules and institutions from different perspectives, seem broadly to agree that these fiscal arrangements may be useful devices to improve the conduct of fiscal policy in terms of better budgetary results and less pro-cyclicality. However, it is also widely acknowledge that the appropriate design of rules and institutions is country-specific, and highly depend on the domestic institutional setting and the nature of the fiscal problems. Programme of the workshop THE ROLE OF FISCAL RULES AND INSTITUTIONS IN SHAPING BUDGETARY OUTCOMES Organised by the European Commission Directorate General for Economic and Financial affairs Brussels, 24 November 2006 Charlemagne Building, room S1 170 rue de la Loi, B-1049 Bruxelles, 8.30-9.00 REGISTRATION AND WELCOME COFFEE 9.00.-9.10 WELCOME ADDRESS BY KLAUS REGLING, Director General, Directorate- General Economic and Financial Affairs 9.10-10.40 SESSION 1 - FISCAL RULES AND INSTITUTIONS AS USEFUL DEVICES TO ADDRESS THE DEFICIT BIAS - CHAIR: SERVAAS DEROOSE (20 minutes per presentation and 30 minutes discussion) Signe Krogstrup and Charles Wyplosz, A Common Pool Theory of Deficit Bias Correction Xavier Debrun and Manmohan Kumar, The Discipline-Enhancing Role of Fiscal Institutions: Theory and Empirical Evidence Teunis Brosens and Peter Wierts, The Surplus Factor − Discussant: C. Martinez-Mongay 10.40–11.00 COFFEE BREAK 11.00-12.00 SESSION 2 - FORMS OF GOVERNANCE, FISCAL RULES AND INSTITUTIONS - CHAIR: SERVAAS DEROOSE (20 minutes per presentation and 20 minutes discussion) Mark Hallerberg, Rolf Strauch and Jürgen von Hagen, The Design of Fiscal Rules and Forms of Governance in European Union Countries Dermot Hodson, National Fiscal Governance and the Stability and Growth Pact: Are "delegation" states at a disadvantage? − Discussant: C. Wyplosz 12.00–13.30 LUNCH 13.30–15.20 SESSION 3 - SPECIFIC INSTITUTIONAL ARRANGEMENTS TO IMPROVE FISCAL POLICY - CHAIR: ELENA FLORES (20 minutes per presentation and 30 minutes discussion) Fabrizio Balassone, Daniele Franco and Stefania Zotteri, Rainy Day Funds: Can They Make a Difference in Europe? Joaquim Ayuso-i-Casals, Diana Gonzalez Hernandez, Laurent Moulin, Alessandro Turrini, Beyond the SGP: Features and effects of EU national-level fiscal rules Mark Hallerberg and Eloïse Stéclebout-Orseau, Who provides signals to voters about government competence on fiscal matters? The importance of independent watchdogs Tatiana Kirsanova, Campbell Leith and Simon Wren-Lewis, Optimal Debt Policy, and an Institutional Proposal to help in its Implementation − Discussant: