Public Information Notice No. 09/139

Public Information Notice: Fiscal Rules Can Help Achieve Sustainable Public Finances, IMF Says

December 22, 2009

On December 4, 2009, the Executive Board of the International Monetary Fund (IMF) held a seminar on “Fiscal Rules—Anchoring Expectations for Sustainable Public Finances.” The staff paper is posted on the IMF’s website at http://www.imf.org/external/index.htm.

Background

The staff paper assesses the usefulness of fiscal rules in supporting fiscal consolidation, examines the evolution of rules using a new database spanning the whole Fund membeship, discusses design and implementation issues, and explores fiscal frameworks that could be adopted as countries emerge from the crisis. This work is part of the IMF’s ongoing analytical research on economic strategies to be adopted after the crisis, as requested by the G-20 and the IMFC.

The paper finds that fiscal rules have become more common in recent years, with almost 80 countries having national or supranational rules in place in early 2009. Rules were on average associated with improved fiscal performance and more prudent fiscal policies. However, they were often implemented not at the beginning of the adjustment phase but later on, to lock-in gains from earlier consolidation efforts.

But the need to address the current global crisis has strained the rules in many cases. The paper argues that, going forward and looking beyond the crisis, rules-based frameworks can be useful in anchoring expectations regarding fiscal sustainability, but they have to reflect country circumstances.

In countries facing large fiscal consolidation needs, a rules-based framework that can guide policy over the long-run could be designed and announced at an early stage. But its immediate implementation could involve an excessively abrupt adjustment. Thus, in these countries, consolidation in its early phase could be guided by a time-bound realistic adjustment plan supported by appropriate policies, before the rules-based framework is implemented.

Executive Board Assessment

Directors welcomed the opportunity to discuss the role that fiscal rules can play in strengthening public finances and enhancing debt sustainability. In recent years, an increasing number of countries—especially members of currency unions and emerging market economies—have relied on fiscal rules to guide fiscal policy. Going forward, Directors noted, interest in fiscal rules is likely to increase further, as countries seek to develop exit strategies to meet the fiscal challenges arising from the financial crisis. Directors concurred that the quality of fiscal policy frameworks and institutions, in particular adequate public financial management systems, are crucial for good fiscal performance and a prerequisite for the effective implementation of fiscal rules. A number of Directors observed that strong policy frameworks, institutions, or track records may be even more important than the existence of a fiscal rule itself.

Directors welcome the new database which contributes to the knowledge about the characteristics and evolution of rules. They encouraged the staff to build on these data to further explore the links between fiscal frameworks and debt sustainability in the current environment.

Directors observed that the use of fiscal rules has been generally associated with improved fiscal performance and more successful fiscal consolidations. As improved outcomes and the introduction of rules could both reflect increased support for fiscal discipline, causality is difficult to establish. Nevertheless, many Directors agreed with staff that evidence suggested that rules had contributed to better performance.

Directors underscored that, to be effective, rules need to strike a balance between providing confidence that targets will be met and allowing adequate flexibility to respond appropriately to output and other shocks. Cyclically adjusted or structural balance rules could prove a viable option for many countries, although, depending on specific circumstances, they could pose challenges as to the communication with the public and the accurate assessment of the cyclical position, in particular during times of high economic uncertainty. In that light, a few Directors suggested that nominal tax or expenditure indicators could provide supplemental information to help guide policymaking under such rules. Directors noted that, depending on country circumstances and capacity, an independent fiscal agency or a fiscal council could play a useful role in supporting the technical requirements for such rules and in monitoring their implementation. Flexibility of fiscal rules may also be needed to respond to a variety of other shocks, including exchange and interest rate volatility as well as commodity price fluctuations. In addition, the possibility of rare events should also be taken into account when designing a rule.

Directors concurred that fiscal rules should be transparent and credible, with a clear link to the ultimate objective of debt sustainability. The type and design of fiscal rules may differ across countries depending on the policy tradeoffs. Directors observed that rules enshrined in higher-level legislation are likely to be more difficult to reverse or abandon, potentially an advantage where political change could undermine the credibility of fiscal policy. They also stressed the importance of subnational rules in countries where different levels of government are responsible for fiscal policy.

Directors agreed that a predefined mechanism to respond to past deviations from fiscal rules is useful if combined with other enforcement tools. The mere introduction of fiscal rules does not guarantee success, unless there are costs of breaking the rule: these can range from both institutional sanctions to the adverse reputational impact of reneging on a public commitment. The failure to meet a rule’s operational target in a given year should not necessarily trigger a response when the deviation reflects nonsystematic or temporary factors. But a fiscal rule that entails a mechanism to respond to unwarranted past deviations enhances credibility. Such a mechanism should clearly lay out the period over which corrective action needs to be taken.

Directors recognized the strain that the current crisis has put on fiscal rules. About a quarter of the countries with only national rules have modified them or put them into abeyance. For a number of others, a conflict between the fiscal rule and the desired policy response was noted, and it was expected that the rules in these countries would also be modified or suspended. Nonetheless, Directors acknowledged that in many countries the existing national frameworks were able to deal with the crisis, aided by flexibility built into numerical constraints or escape clauses. They also noted that no supranational rules had been changed in response to the crisis.

Looking ahead, Directors agreed that rules based frameworks could play an important role in enhancing confidence and anchor expectations regarding fiscal sustainability. However, it was essential for these frameworks to be tailored to countries’ circumstances. In countries where the current adjustment needs are large, a time-bound realistic consolidation plan backed by appropriate benchmarks and policies would help to guide the required debt reduction, laying the basis for a credible rule-based framework when economic conditions have normalized.