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

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.