First glance

The EU needs a methodology for including reform impacts in fiscal trajectories

Such a methodology, and a governance mechanism for managing associated risks, must be in place before the new fiscal framework kickstarts in September

Publishing date
26 March 2024

In addition to ensuring fiscal sustainability, the European Union’s new fiscal framework aims to encourage structural reform and public investment in member countries. Normally, governments in countries with excessive deficits or debts have four years to bring their finances in line with fiscal requirements, but as an incentive for reform and investment, this can be extended to seven years. This would mean that the annual fiscal adjustment requirement can be reduced from a level that might be politically and economically very painful to something more feasible.

To obtain the extension, reforms and investments proposed by EU countries should be growth-enhancing, supportive of fiscal sustainability and in line with common EU priorities. Nationally financed public investments should increase. Meeting all requirements could be tough. Countries set out reform and investment proposals in their medium-term fiscal-structural plans (MTFSPs). The European Commission will evaluate whether the conditions for an extension to seven years are met. 

Oddly, however, as we explain in a recent working paper, the European Commission lacks a methodology to quantify the impact of reforms and investment on growth and fiscal sustainability, except for labour-market reforms and measures related to the fiscal costs of ageing. In particular, the Commission’s forecasting methods do not capture the impact of reforms and investment on total factor productivity (TFP) and the capital stock, unless these are expected to be felt in the first two years of the forecast, after which these impacts are assumed to fade away. 

Neither do there seem to be plans for developing such a methodology, apparently for two reasons. First, Commission forecasts only seek to take into account reforms that are already adopted. To help them draft their MTFSPs, the Commission will provide EU countries with ‘reference trajectories’ that show the fiscal path they should take, but proposed reforms are not factored into this. Second, the impact of reform and investment on potential output is notoriously hard to assess quantitatively. The Commission thus prefers to subject the proposed reforms only to a qualitative plausibility check, disregarding any quantitative impact on the fiscal trajectory. 

In our view, this approach is not satisfactory. The Commission and the Council should develop a methodology for the quantitative impact of proposed reforms on the fiscal path, together with a process for managing risks, for three reasons. 

First, an MTFSP is permitted to deviate from the Commission’s reference trajectory if a member state provides “sound and data-driven economic arguments explaining the difference”. Planned reform and investment recognised as growth enhancing and sustainability supporting would be an excellent justification for such deviations. Thus, the Commission will have to evaluate whether the trade-off between fiscal adjustment and the reforms assumed in an MTFSP is quantitatively reasonable or not.  

Second, the Commission’s forecasting methodology is unsuitable for assessing the impact of recently adopted reforms on TFP and the capital stock for the same reasons why it cannot be used to assess proposed reforms: the impact of these reforms may not show up in the near-term forecast, and even when it does, it is assumed to dissipate over time. A methodology that helps the Commission quantify the impact of reforms (be they adopted or proposed) would thus also help it to prepare the reference scenario.  

Third, a methodology that quantifies the impact of reform and investment on growth would allow the Commission and the Council to head off the debate of what can be labelled a ‘reform’ or an ‘investment’. In particular, EU countries disagree about whether ‘social investment’ – measures improving human capital and raising labour force participation – should qualify as investment and reform. Critics fear that EU countries will classify unproductive social spending as reform. This would be impossible if a reform – social or not – counts for the purposes of the new fiscal framework based only on its expected impact on potential output.

Developing a methodology for quantifying the impact of both planned and recently adopted reforms will require revisiting the current methodologies for projecting the medium- and long-term capital stock and TFP. Once a revised approach is agreed, it could be used by both the Commission and EU countries, ensuring consistent calculations. Meanwhile, the Commission and EU countries should agree on a procedure for taking into account uncertainty about the implementation of reforms and their economic effects. Implementation risk can be dealt with through benchmarks that help decide whether a reform or investment plan has been implemented as expected, and by adopting a backup fiscal trajectory, involving greater adjustment requirements, that will be triggered if the benchmarks are not met. Uncertainty about the expected impact of reform can be managed by taking a conservative view of reform impacts. 

The Commission and EU countries have no time to lose. For the new fiscal framework to get off to a good start, a methodology to quantify reform and investment impacts, and a governance mechanism for managing associated risks, must be in place before the first MTFSPs are due in September.

About the authors

  • Zsolt Darvas

    Zsolt Darvas is a Senior Fellow at Bruegel and part-time Senior Research Fellow at the Corvinus University of Budapest. He joined Bruegel in 2008 as a Visiting Fellow, and became a Research Fellow in 2009 and a Senior Fellow in 2013.

    From 2005 to 2008, he was the Research Advisor of the Argenta Financial Research Group in Budapest. Before that, he worked at the research unit of the Central Bank of Hungary (1994-2005) where he served as Deputy Head.

    Zsolt holds a Ph.D. in Economics from Corvinus University of Budapest where he teaches courses in Econometrics but also at other institutions since 1994. His research interests include macroeconomics, international economics, central banking and time series analysis.

  • Lennard Welslau

    Lennard is a Research analyst at Bruegel. His research interests lie in the fields of macroeconomics, international economics, and data science. He studied Philosophy, Politics and Economics in Freiburg and Buenos Aires and holds an MSc in Economics from the University of Copenhagen. In his thesis, he used a small open economy heterogeneous agent New Keynesian (HANK) model to investigate the role of wage flexibility in countries facing external demand and interest rate shocks.

    Prior to joining Bruegel, he worked as a trainee with the European Central Bank, held research assistant positions at the Walter Eucken Institute and the Copenhagen Business School, and contributed to the work of the UN Economic Commission for Latin America and the Caribbean (ECLAC) as a research consultant, working on empirical trade modelling.

    Lennard is a native German speaker and is fluent in English and Spanish.

  • Jeromin Zettelmeyer

    Jeromin Zettelmeyer has been Director of Bruegel since September 2022. Born in Madrid in 1964, Jeromin was previously a Deputy Director of the Strategy and Policy Review Department of the International Monetary Fund (IMF). Prior to that, he was Dennis Weatherstone Senior Fellow (2019) and Senior Fellow (2016-19) at the Peterson Institute for International Economics, Director-General for Economic Policy at the German Federal Ministry for Economic Affairs and Energy (2014-16); Director of Research and Deputy Chief Economist at the European Bank for Reconstruction and Development (2008-2014), and an IMF staff member, where he worked in the Research, Western Hemisphere, and European II Departments (1994-2008).

    Jeromin holds a Ph.D. in economics from MIT (1995) and an economics degree from the University of Bonn (1990). He is a Research Fellow in the International Macroeconomics Programme of the Centre for Economic Policy Research (CEPR), and a member of the CEPR’s Research and Policy Network on European economic architecture, which he helped found. He is also a member of CESIfo. He has published widely on topics including financial crises, sovereign debt, economic growth, transition to market, and Europe’s monetary union. His recent research interests include EMU economic architecture, sovereign debt, debt and climate, and the return of economic nationalism in advanced and emerging market countries.    

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