Fiscal rule legislative proposal: what has changed, what has not, what is unclear?

The main gist of the European Commission’s economic governance reform proposal is to create a conceptually new system focusing on debt sustainability (Blanchard et al, 2021) and a single operational indicator, which is a measure of public expenditure growth. This would replace the current unfavourable system of fiscal rules (Caleys et al, 2016). Many similar reforms were proposed years ago (Darvas et al, 2018). Further attractive features of the European Commission’s proposal are the integration of fiscal and macroeconomic imbalance surveillance, the requirement for comprehensive national fiscal-structural plans and the requirement for making all relevant documents publicly available. The main conceptual basis and the boldness of the proposal are welcome.

Ashes and relics of past rules

The one-twentieth debt reduction rule (reducing the debt ratio by the one-twentieth of the excess over the 60 percent criterion annually) and the medium-term objective (MTO) requirements for the structural budget balance (actual budget balance cleaned from the impacts of cyclical and one-off effects) have been proposed to be removed from the fiscal framework. This is good news. The one-twentieth rule could require excessive fiscal adjustment in some cases and this rule was anyway disregarded when Belgium and Italy repeatedly violated it. The structural balance is a very unreliable indicator (Darvas, 2021).

The EU Treaty-based 3 percent of GDP deficit criterion and the requirement to reduce the debt ratio when it is over 60 percent of GDP remain.

New fiscal requirements

The main new requirement is that the net expenditure path set by the national fiscal-structural plan should ensure that the public debt ratio is on a “plausibly downward path” when it is about 60 percent. When it is below 60 percent, it should remain at “prudent levels”. The plausibility assessment checks if the debt ratio is declining in a deterministic projection and if there is a “sufficiently low” probability (numerical value not stated) that it will not decline according to a stochastic analysis.

There are three additional requirements for all countries:

• The 3 percent deficit criterion must be met under unchanged policies over a period of ten years after the adjustment period (which could last from four to seven years).
• No backloading: the average annual adjustment over the “period of the national medium-term fiscal structural plan” should not be lower than the average over the “entire adjustment period”.
• Reduced debt ratio: the debt ratio at the end of the “planning horizon” must be smaller than before the period began.

An important ambiguity is that the draft regulation does not define the “planning horizon” and whether it is four or seven years when the adjustment period is extended to seven years. It is stated in the draft regulation that the plan should present various trajectories for “a period of at least 4 years”, which implies the plan can cover more than four years. Also, a seven-year long adjustment period must imply there is seven-year planning. On the other hand, the no backloading condition differentiates between the period of the plan and the adjustment period.

My calculations suggest that it would make a sizeable difference for Belgium and France in the initial adjustment needs if the reduced debt ratio requirement applies for four years or seven years ahead.

A maintained but ambiguous adjustment requirement

For countries under an excessive deficit procedure (EDP), an additional condition must be met too. This is not really a new requirement as a very similar provision exists in the current framework. The new requirement:

• “For the years when the general government deficit is expected to exceed the reference value, the corrective net expenditure path shall be consistent with a minimum annual adjustment of at least 0,5% of GDP as a benchmark."

A source of ambiguity is that the indicator to which the half percent adjustment refers is not defined in the legislative proposal (nor in the press release or Q&A). The cited sentence replaces the requirement of “a minimum annual improvement of at least 0,5%  of GDP as a benchmark, in its cyclically adjusted balance net of one-off and temporary measures”, which is the structural budget balance (Article 3(4) of the current EDP regulation). The explanatory memorandum of the legislative proposal states that “a minimum annual adjustment of at least 0,5% of GDP as a benchmark is maintained”, which may suggest that the adjustment continues to be measured in the structural balance.

However, after the European Commission’s press conference, some initial reports stated that the debt ratio must be reduced by 0.5 percent of GDP per year. This was corrected a day later to the requirement that “countries would need to reduce their net expenditure by at least 0,5% of GDP per year”. Such a requirement, which literally means lowering the nominal value of net expenditures, would not make sense, especially at a time of high inflation.

European Commission guidance

The European Commission will guide the preparation of national plans by preparing a “technical trajectory” for expenditure growth, but only for countries which have more than a 3 percent deficit or more than 60 percent debt.

Interestingly, more criteria are required for the technical trajectory than for the expenditure path in the national plan. The growth rate of net expenditures must be lower than medium-term output growth for countries breaching either the 3 percent deficit or the 60 percent debt criteria. This requirement is only for the preparation of the technical trajectory (Article 6 and Annex I of the draft regulation) and is not listed for the expenditure path of the national plan (Article 15).

The European Commission will also calculate the structural primary balance corresponding to the expenditure path. Time will tell whether the structural primary balance or the expenditure path will get greater attention: it would be more beneficial to focus on the expenditure path, which has major conceptual advantages over structural balances.

For countries who have lower than 3 percent deficit and lower than 60 percent debt, the European Commission will not prepare a technical trajectory, but will instead calculate the structural primary balance needed to keep the deficit below 3 percent.

The proposed framework divides countries into three main groups

Group 1: Excessive deficit procedure (EDP) countries

Two conditions can lead to an EDP. One is the usual 3 percent deficit criterion (“deficit-based EDP"). The other which applies to countries whose public debt ratios are above 60 percent, the violation of the approved expenditure path might also lead to EDP (“debt-based EDP”). Naturally, some years will have to pass until violation of the expenditure path can be assessed.

Seven EU countries (Belgium, France, Italy, Poland, Romania, Slovakia and Spain) are expected to violate the deficit criterion in 2024 and 2025 according to the latest IMF forecast. Among those countries, the new reduced debt reduction criterion would likely constrain Belgium and possibly France, especially if the reduced debt ratio criterion applies for four years, not seven years, and if fiscal adjustment would reduce GDP. For the other five countries, the 0.5 percent minimum annual adjustment criterion is tougher, according to my calculations.

Bulgaria, Estonia, and Malta are also forecast to have slightly more than a 3 percent deficit in 2024, but less than 3 percent in 2025. Those three countries have less than 60 percent debt ratios, so they might avoid an EDP.

Group 2: Countries with lower than 3 percent budget deficit and higher than 60 percent public debt

Nine countries would likely fall into this category in 2024. They include Austria, Croatia, Cyprus, Finland, Germany, Greece, Hungary, Portugal and Slovenia. Among those countries, only Finland would violate the reduced debt ratio criterion according to the IMF forecasts. However, the IMF does not expect fiscal consolidation in Finland from 2024-2028.

Group 3: Countries with lower than 3 percent budget deficit and lower than 60 percent public debt

The remaining 11 countries (Bulgaria, Czechia, Denmark, Estonia, Ireland, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Sweden) will likely fall in this category in 2024. The proposal requires these countries to prepare fiscal-structural plans which the European Commission will then analyse, including the reduced debt ratio criterion. However, no consequence is foreseen if that criterion is not met unless the debt ratio exceeds 60 percent. Thus, beyond the European Commission monitoring the compliance with the 3 percent deficit and 60 percent debt criteria, fiscal policies of these countries will be determined by national frameworks.

Missed opportunity to foster green transition

Countries in groups 1 and 2 must cut deficits and some countries in group 3 might cut too. According to IMF forecasts, six of the 11 countries in group 3 will implement fiscal consolidation between 1 percent and 3.5 percent of annual GDP in total in the period from 2023-2028. Politicians prefer cutting investment over current spending and unpopular tax increases, partly because the interests of future generations have less electoral support.

A good solution for fostering climate transition would have been to exclude net green public investment from the fiscal indicators used to measure compliance with the EU’s fiscal rules for countries without substantial debt challenges (Darvas and Wolff, 2022). The European Commission’s Q&A suggests there was no consensus on this issue, but the proposal aims to promote investment through a medium-fiscal adjustment path. At least information will have to be provided: the national plans should detail total public investment expenditure, as well as reforms and public investment expenditure addressing the common priorities of the EU, including the European Green Deal. Subsequent annual progress reports must report on actual progress and planned investment.

However, since most EU countries will implement fiscal consolidation in the years to come, which often coincide with cuts to public investment, while there is an urgency to increase green public investment, it’s hard to see how politicians will cut non-climate spending even more to make room for increased climate spending. A lack of a substantial increase in green public spending risks the EU missing its climate targets, which could diminish the determination of non-EU countries to reach their own. But damage to the climate is irreversible.