Blog Post

Reforming the EU fiscal framework

Researchers have often highlighted the problematic nature of the currently very complex EU fiscal framework. Here we review economists’ views on how it should be changed.

By: Date: September 17, 2018 Topic: Macroeconomic policy

VoxEU has been publishing a number of contributions on reforming the EU fiscal framework. Coen Teulings thinks that the EU fiscal rules urgently need revision, because the fiscal rules in the Stability and Growth Pact were too strict and their update – laid down in the new European Fiscal Compact – made matters worse. The euro area’s demography makes a 60% sovereign debt more of a lower bound than an upper bound.

The rules should allow, during a bad recession, for an upper bound to fiscal deficit of 5-6% of GDP, but the Stability and Growth only allows for 3%. The Fiscal Compact added that the structural deficit must not exceed 1 % of GDP. This corresponds to a level of sovereign debt of 33% of GDP. So, if the member states will live by the rules during the next decades, the euro area is heading for an unprecedented decline of public debt. The more likely outcome is the rules being simply ignored. But then it is better to revise them now, so that member states can be held accountable when violating them.

Xavier Debrun, Luc Eyraud, Andrew Hodge, Victor Lledo and Catherine Pattillosummarise lessons from recent research on fiscal rules, including the new generation of ‘smart’ rules that emerged around the Global Crisis, to answer the question of whether numerical constraints on broad indicators of fiscal performance can contain politicians’ penchant for borrowing too much and at the wrong time.

They argue that rules can mitigate fiscal excesses if they strike a good balance between simplicity, flexibility, and enforceability. In particular, well-designed fiscal rules should follow three principles, in the view of Debrun et al.: (i) get the overall design right, through a parsimonious set of mutually consistent rules anchored in sustainable public debt trajectories; (ii) move away from sanctions, as incentives to comply with rules seem to stem more from reputational factors than non-credible threats of sanctions; (iii) cater for simplicity.

The 7+7 Franco-German economists’ paper published in January suggested a two-pillar approach, consisting of (1) a long-term target debt level, such as 60% of GDP, or a more bespoke objective taking into account, for example, implicit liabilities arising from pay-as-you-go pension systems; and (2) an expenditure-based operational rule to achieve the anchor.

Zsolt Darvas, Philippe Martin and Xavier Ragot elaborate on this and make the economic case for an expenditure rule in Europe. The current framework has suffered from procyclicality: there was insufficient debt reduction in many countries during the ‘good times’ in the 2000s, and this in turn reduced fiscal capacity during the bad years of the crisis. In addition, the current rules – centred on the concept of structural budget – suffered from large measurement problems.

Darvas, Martin and Ragot recommend substituting the present rules with a new, simple expenditure rule requiring that nominal expenditures not grow faster than long-term nominal income, and that they grow at a slower pace in countries with excessive levels of debt. By recognising the limitation of one-size-fits, instead of a set-in-stone numerical formula, the authors recommend an expenditure rule based on a rolling five-year country-specific debt reduction target in a properly designed institutional framework. Simulations based on French data suggest that, depending on the degree of ambition of the five-year debt reduction target, the expenditure rule can generate debt reduction dynamics that are similar or less stringent than the present rule. The rule has good countercyclical properties for unexpected demand shocks.

Lars Feld, Christoph Schmidt, Isabel Schnabel, Volker Wieland portend that the opacity and complexity of the current EU fiscal framework implies that the rules are not sufficiently effective in confining the deficit bias of governments and ensuring sustainable public finances. They propose a re-focused framework with a long-term public debt limit. In contrast to other proposals, this one however retains as a key element the structural balanced budget rule as stated in the Fiscal Compact. For monitoring purposes, the long-term debt rule and the medium-term structural balance rule are operationalised at the annual level with an expenditure rule in the form of an annual ceiling. They also specify a multi-purpose adjustment account, which should ensure compliance with the structural deficit rule in the medium term by capturing deviations from the rule, with the requirement to offset them within a certain period of time.

The authors argue that this proposal might not require a complete overhaul of the European framework and treaties, and would therefore be easier to put into practice than other proposals. It would simplify the public debate about the adherence to fiscal rules, as the focus would be shifted towards the easy-to-grasp expenditure rule and the adjustment account, while reducing exceptions and escape clauses. The framework would also be consistent with the existing national rules introduced in the member states owing to their participation in the Fiscal Compact.

Thomas Wieser looks at the challenges to the central role of the Commission that have arisen as the rules-based fiscal framework has been severely compromised. The present rules-based system of the Stability and Growth Pact (SGP) has become nearly unmanageable due to its complexity, and the constant addition of exceptions, escape clauses, and other factors. The set-up of rules and procedures forces the Commission into a choice between proposing sanctions on the basis of shaky forecasts, or not proposing sanctions despite the rules requiring them. If the Commission does not wish to sanction deviations, it again and again has to devise a new rule that explains why fiscal reality is in conformity with rules.

This ‘political’ behaviour contrasts with a fairly stable rules-based system, up to around 2010, where the Commission by and large executed the rules without an overuse of discretion. The present situation calls for simpler rules that actually can be understood by those who are responsible for fiscal policy in member states. The Commission should  remain at the centre of the system, and needs to be be given a wider margin of discretion for applying the fiscal rules; if there are noticeable deviations that the Commission does not act upon, then it should have to publicly explain itself before the Council, the Eurogroup and also the European Parliament.


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