Second Generation Fiscal Rules: Balancing Credibility, Flexibility, and Simplicity

Monday, May 7

Presenter
Mr. Victor Lledo, Senior Economist, International Monetary Fund


Summary

On May 7, 2018, the JVI hosted a public lecture on “Second Generation Fiscal Rules: Balancing Credibility, Flexibility, and Simplicity[1]” by Victor Lledó, Senior Economist in the IMF Fiscal Affairs Department. The presentation was based on research Mr. Lledó carried out with colleagues Luc Eyraud, Xavier Debrun, Andrew Hodge, and Catherine Pattillo, which was published as an IMF Staff Discussion Note.[2]

The purposes of the research were to (1) revisit the case for fiscal rules in light of experience, (2) examine how developments since the global financial crisis (GFC) led to a new generation of rules, and (3) contribute to current debate on the topic.

The main goals of fiscal rules are to commit policymakers to fiscal sustainability, enhance transparency, and signal to financial markets the course of fiscal policy. Rules can also have a political function by catalyzing agreement on sound fiscal strategies. Though today more than 90 countries use them, fiscal rules are often criticized for being too rigid and complicated and for having a poor compliance record.

Mr. Lledó posited that, to be effective, fiscal rules should have three properties: simplicity, flexibility, and enforceability. However, these properties are difficult to achieve simultaneously, and countries designing a rule struggle to find the right balance.

Post-GFC reforms have made rules more flexible by, for example, adding escape clauses. The reforms have also made the rules easier to enforce, by introducing independent fiscal councils, broader sanctions, and correction mechanisms. However, these innovations have made fiscal rules more complicated to administer, although there has been moderate progress in achieving compliance.

Mr. Lledó and his co-authors examined the effectiveness of rules by looking at how well they reduce deficits. Their findings suggest that there is no universal impact: the effectiveness of a rule depends on how it was designed and varies by country and by the type of rule. Designing a successful rule needs to take into account broad economic and institutional coverage, good calibration, well-designed escape clauses, effective supporting institutions—plus sound public financial management and political buy-in.

In designing future fiscal rules, the authors suggested three general principles: (1) Fiscal frameworks should be designed and reformed as a whole, with the intention of establishing an explicit fiscal anchor, limiting the number of rules, and ensuring that the rules adopted are consistent. (2) To be resilient and credible, rules must be flexible, simple, and transparent. (3) Finally, countries should strive to reinforce compliance. Stronger incentives such as raising the reputational cost of breaches can make fiscal rules work politically.

At the Q&A session that followed Mr. Lledó’s presentation, the audience asked about the optimal balance between simplicity and flexibility in designing fiscal rules, and whether simple is always the best criterion for a rule. Many also raised concerns about political constraints, enforcement of rules, and the risks related to contingent liabilities. Mr. Lledó agreed that success stories are not always easy to find and are often time and context specific but warned that rules should not be solely judged by their compliance record. Empirical evidence shows that rules have proved to have an effect in containing excessive deficits even when not complied with. Nonetheless, he reiterated that if rules are to be more effective, better design, good calibration, and strong supporting institutions are imperative.

Asel Isakova, Economist, JVI

 


[1] There is no established definition of “second generation rules.” The authors define them as rules introduced since the Global Financial Crisis.

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