The Case for Spending Rules

Abstract

According to the Stability and Growth Pact (SGP), European countries should achieve a budgetary position ‘close to balance or in surplus’ over the medium term while keeping the public deficit within the value of 3 per cent of GDP. The ‘close to balance or in surplus’ target is usually interpreted as applying to the cyclically-adjusted fiscal balance: the governments should let the automatic stabilisers operate freely, with discretionary policy being the exception rather than the norm. Such type of behaviour implies a substantial change compared to the past experience: empirical evidence indicates that European fiscal policies have tended to behave pro-cyclically. However, the ‘close to balance or in surplus’ target is a guideline rather than a rule as there is no process to sanction deviations from this objective.

Within the boundaries of the Maastricht Treaty and of the SGP, a number of European countries have complemented the SGP with multi-year frameworks. These frameworks are designed to ensure consistency between the SGP and the medium-term objectives for the debt and the government share in the economy. In addition they bring more discipline to fiscal policy-making during ‘good times’.

The objective of the paper is to shed light on the usefulness of a medium-term framework anchoring fiscal policy on spending rules. Although it is widely recognised that expenditure-based fiscal retrenchments are more successful that tax-based consolidations (Alesina and Perotti, 1997; Zaghini, 1999), permanent spending rules have not retained much attention in the economic literature. We argue here that a spending rule curbs the tendency to relax fiscal policy during ‘good times’, hence preserving the free operation of automatic stabilisers on the revenue side. The first section of the paper discusses to what extent a stable cyclically-adjusted position – ‘close to balance or in surplus’ - can be seen as a relevant target for fiscal policy. In a second section, we draw the lessons from the difficulty to adjust for the cycle in real time: a spending rule is more transparent than a cyclically-adjusted balance and more operationally targeted. The spending rule could be usefully inserted in a medium-term framework to ensure ex post compliance and to avoid excessive tax cuts during ‘good times’. The framework should, in particular, specify how expenditure overruns should be clawed back in the following years and how ‘growth dividends’ and revenues overshoots should be used.