Fiscal rules are not a new policy tool, but have only been recently gaining wider attention from economists and general public. The first modern fiscal rule was adopted in Japan (1947) which stipulated balanced budget; followed by Malaysia (1959) with a ’’golden rule’’; Indonesia (1967) with a 3% deficit rule and Australia (1985) which eliminated imposition of new taxes, and increase in expenditures from benchmark values.
By introducing fiscal rules, countries eliminate discretionary fiscal policy by politicians. As most countries are not averse to Keynesian style active fiscal policy during economic downturns of the business cycle, they incur large deficits by increased expenditures and decreased revenue. However, the reverse side of this coin is that in boom part of the business cycle governments should decrease spending and make precautionary savings from which to finance future bust episodes. As James Buchanan noted in his famous essay ’’Democracy in Deficit’’, democratic countries due to innate nature of democratic political process tend to increase spending during the bad but not decrease spending during the good years. The simple explanation is that politicians want to be reelected, and that it is very hard to be reelected if you do not provide your constituencies with new promises of social services. As Buchanan noted, if we are to choose between democracy and deficit, since the piled deficits in the form of public debt cannot continue to increase forever (as the case of Greece still demonstrates), it is better to choose democracy and eliminate the possibility for government to follow active budget policy. Since this proposed solution was considered to widen the amplitude of the boom and bust cycle, automatic stabilizers were introduced. Automatic stabilizers are non-discretionary elements of fiscal policy that stabilize economy during the business cycle, increasing government expenditures during a bust and decreasing it during the boom. Since their level is not decided by politicians or bureaucrats, but by the state of the economy, there is no room for disretionary decision making. Progressive taxation and unemployment benefits are considered as examples of automatic stabilizers. Fiscal rules, in forms of regulations, laws and even constitutions, should serve the similar role, constraining discretionary fiscal decisions that could lead to a unsustainable fiscal position.
In brief, there are several possible fiscal rules:
- Balance budget rule - governement finances need to be balanced or the there is a ceiling of deficit level, during a noted period (a year or a business cycle)
- Debt rule - the level of public debt should not exceed a certain treshold
- Expenditure rule - public expenditures are not exceed a certain treshold
- Revenue rule - public revenues are not to exceed a certain treshold
However, the most usual situation is a combination of two or three rules at the same time. The IMF Fiscal Rules Dataset, covering the period of 1985 - 2015, shows that 77 countries introduced some form of a fiscal rule, but that only 12 (15%) had only one rule. Two rules were introduced in 23 countries (30%) and three rules in the remaining 42 countries (55%). The region with the most fiscal rules is Europe, where there are not only national but also supranational fiscal rules, stemming from EU or euro zone membership.
The ’’golden rule’’ is the most widely accepted fiscal rule. It’s main appeal is the fact that it circumvents the main argument against fiscal rules: that they constrain fiscal policy so it is impossible to lead active budgetary policy during economic downturns. The rule stipulates balanced budget for current expenditures, but allows deficits for capital expenditures - this not only allows active budget policy (through public capital investments), but also enhances its results, since capital expenses are considered more beneficial to growth due to higher multiplier.
Good fiscal rules should be simple enough so they can be understood by the wider public, and not only by trained economists. They should also be thorough, covering all important aspects of the fiscal policy (for example, a country with an elevated level of public debt should have not only deficit or balanced budget rule, but also a debt rule). And of course, it should be legally binding, and overseen by an independent public authority. In this case, politicians could be more easily held accountable if they try to break the rules.
In Europe, fiscal rules were widely introduced by the EU intergation process, with the Maastricht treaty (1992). These rules, regarding the level of public debt and deficit, were later enhanced, with the Stability and Growth Pact (1997) and its ammendments in 2005, and especially after the Greek and eurozone crisis, 2011 -2013 and 2015. Since many European countries are faced with elevated public debt levels (for example, 90% of GDP in auro area), as well as fiscal pressures stemming from demographic changes due to low fertility rates and longer increased life expectancy, with health and pension systems expected to further deteriorate, fiscal rules in the Old Continent seem to be an inevitable policy tool to put the fiscal situation on a long term sustainable path.