CONCEPT NOTE

PEMPAL 2016BCoP Plenary Meeting

FISCAL RULES FOR EFFECTIVE AND SUSTAINABLE BUDGETING

February 24-26, 2016

Minsk, Belarus

Renaissance Hotel

Dzerzhinsky Avenue, 1E, Minsk

Background

PEMPAL aims for its member Governments from Europe and Central Asia (ECA) to more efficiently and effectively use public monies resulting from applying new PFM practices. It does this by providing a sustainable, professional public financial management platform through which individual members are networked to strengthen their capacities and to enable them to share learnings and benchmarking between countries.[1]The Budget Community of Practice (BCoP) of PEMPAL focuses on enhancing budget policy and methodology. PEMPAL ( was launched in 2006 with the help of the World Bank and a number of donors, and is currently supported by the World Bank, the Ministry of Finance of the Russian Federation, and the Swiss State Secretariat for Economic Affairs (SECO).

The Budget Community of Practice of PEMPAL, led by the BCOP Executive Committee,[2]organizes plenary meetings of its members on an annual basis to discusscommon public finance reform issues. In addition to these annual meetings, it also operates two working groups comprising a sub-set of its 21 member countries, on budget literacy and wage bill management which meet more regularly via video-conference and periodically face-to-face. Study visits to specific countries are also held to examine reforms more in-depth. BCOP held 14 knowledge sharing and learning events during2013 and 2014. In 2015, BCOP held 12 events (half of which were video-conference meetings).

For the plenary meeting of 2016,fiscal rules for effective and sustainable budgeting was chosen by member countries to be the theme. Since the late 1990s many countries have adopted fiscal rules to guide their fiscal policy processes. Fiscal rules gained more prominence as a credible medium-term anchor after the financial crisis whereaccording to the IMF, about a quarter of its member countries with national rules, modified them or put them into abeyance.[3]Those PEMPAL members who are current and candidate members of the European Union have also been faced with strengthened fiscal governance measures under the enhanced Stability and Growth Pact, which was more clearly specified in response to the crisis andincludesmedium-term budgetary targets. Further, Eurozone countries are now obliged to include the fiscal rules in national law.[4]

Countries also face medium and long-term structural challenges that negatively impact their ability to deliver a national budget in an effective and sustainable manner.For example, many countries face declining working populations and rising dependency ratios, which risk making existing entitlement programs unaffordable.To manage these challenges, some countries have derived long-term sustainability analyses extending 30 to 50 years ahead. TheEuropean Commission examined budgetary projections from 2013 to 2060 in its Member States and found the fiscal impact of aging to be high, with a 2 percent of GDP projected rise in public age related expenditures to 2060 which has significant implications on fiscal sustainability. [5]

Long-term economic and budgetary projections can provide guidance to key structural challenges. There is no best practice approach and different countries have adopted different methodologies centered onlong-term expenditure, revenue, demographic, resource, and climatic projections. The results from this long-term analysis have been used to inform current budget policies, such as, for example, for retirement age, pensions, and health care financing. The main benefit from this long-term planning is to develop strategies to strengthen fiscal policies to meet future challenges.

Definitions and Concepts[6]

Afiscal ruleimposes a constraint onfiscalpolicy through numerical limits on budgetary aggregates.Numerical limits are usually expressed in terms of constraints on fiscal outcomes for government budget balance, debt, expenditure, or revenue:

  • Budget balance rulesdirectly target the fiscal balance (i.e. the gap between government spending and revenues), e.g. a requirement to run a balanced position; not to exceed a defined deficit limit; or a requirement to attain a defined surplus at minimum. Such rules are usually expressed as a percentage of GDP. Examples include Indonesia, Israel, and EU countries where the overall deficit ceiling of 3 percent of GDP is applied and Sweden where a surplus of 1 percent of GDP over the cycle is set as a target. Variations of balance rules are:
  • “Golden Rule” in which the government is only allowed to borrow to finance investments. The rationale underlying the golden rule is that investments represent future, and not current, consumption and have the potential to generate future growth.[7]Examples include Brazil, Malaysia.
  • ‘Second generation’ or ‘next generation’ rulesrefer to thosebudget balance rules which use cyclically-adjusted targets.They combine the objectives of sustainability with the need for flexibility to respond to shocks. For example, targeting a cyclically adjusted or structural balance rather than the nominal balance; or commodity exporters using a structural balance adjusted for commodity revenue fluctuations or usinga non-commodity balance.
  • Debt rulesset an explicit limit or target for public debt in percent of GDP. Examples include a debt ceiling of 60 percent of GDP as applied in Liberia and EU countries.
  • ‘Debt brake’ rules refer toseveral variations. For example,Switzerland uses a structural deficit rule that limits expenditures to the amount of structural (or cyclically-adjusted) revenues; in Germany, central and state government must achieve balanced budgets without incurring new debt;the European Union’s Stability and Growth Pact defines the rate at which debt levels above the limit of 60% of GDP shall decrease.
  • Expenditure rulesset permanent limits on total, primary, or current spending in absolute terms, growth rates, or in percent of GDP. Examples include Namibia where public expenditure levels must be below 30 percent of GDP; Peru where real growth of current expenditure must be within a ceiling of 4 percent; and Germany where expenditure cannot grow faster, on average than revenue;
  • Revenue rulesset ceilings or floors on revenues and are aimed at boosting revenue collection and/or preventing an excessive tax burden. Examples include Kenya which must maintain revenues at 21-22 percent of GDP; and Belgium where growth of revenues has to be in line with GDP growth.

In addition to numerical targets, fiscal rules can also establish procedures for the budgetary process i.e. procedural rules with a view to establishing good practices, raising predictability, and transparency.IMF, for the purposes of its fiscal rules dataset, includes not only those numerical targets fixed in legislation, but fiscal arrangements such as expenditure ceilings as fiscal rules as long as they can only be revised on a low-frequency basis i.e. ceilings are binding for a minimum of three years. Thus, medium-term budgetary frameworks or expenditure ceilings that provide multi-year projections but can be changed annually are not considered to be rules.

Effective fiscal rules share several fundamental characteristics. According to the OECD, a fiscal rule serves as a concrete indicator of the executive’s fiscal management and constrain politically-motivated spending to improve macroeconomic stability in the short-term, while contributing to long-term fiscal sustainability. [8]Other good characteristics include:

  • A fiscal rule must have a clear objective. According to the IMF,[9] an effective fiscal rule must have an unambiguous and stable link between the numerical target and the ultimate objective, such as debt sustainability. Apart from debt and fiscal sustainability objectives, fiscal rules have also been introduced to meet other objectives. For example, to contain the size of the government, to support intergenerational equity, and to facilitate effective use of natural resource revenues.
  • Fiscal rules also need sufficient flexibility to respond to shocks. According to the IMF, flexibility may be needed to deal with output, inflation, interest rate and exchange rate volatility, and other unanticipated shocks such as national disasters.[10] This has led to “second generation” or “next-generation” rules, which are typically comprised of cyclically-adjusted targets. The IMF found that these rules are associated with less procyclicality, well-defined escape clauses, andstronger legal and enforcement arrangements.[11] TheIMF recommendsthat such rules should have adequate flexibility to respond to shocks while also being “readily operationalized, communicated to the public, and monitored.”[12]
  • Fiscal rules need appropriate institutions for monitoring and enforcement mechanisms, andneed to be supported by strong political commitment.

Some countries have also establishedindependent monitoring bodies, such as fiscal councils, to further enhance the credibility of the rules.[13]This oversight mechanism is important to monitor the implementation of fiscal rules since there may be pressures within government to usecreative accounting methods to circumvent a particular rule.[14]

OECD and IMF have also made recommendations on the type and mix of fiscal rules. OECD recommends debt targets to act as a fiscal policy anchor to ensure the sustainability of fiscal policy and to provide sufficient policy room to cope with adverse shocks.[15]A recent IMF study[16] found expenditure rulesshowed higher compliance than other rules and were associated with spending control, counter-cyclical fiscal policy, and improved fiscal discipline. However, to strengthen compliance, the IMF found that the most effective expenditure rules tend to cover at least three-quarters of central government expenditure and have a clearly-defined set of criteria for exclusion of expenditure items. Successful implementation also requires regular, comprehensive reviews of government expenditure. Finally, the IMF recommends that governments leave themselves room for maneuver within their expenditure plans in the form of contingency reserves and contingency planning.[17]

Data on Application of Fiscal Rules and PEMPAL Countries Performance

The European Commission maintains a database of fiscal rules being used by its member countries since 1990.[18] This database includes 28 member states of which five are PEMPAL member countries (Bulgaria, Croatia,Romania and IACOP members Hungary and Czech Republic). Fiscal rules applying to member states include a limit of 3 percent of GDP for the fiscal deficit. If the deficit exceeds that limit an ‘excessive deficit procedure’ is initiated to bring levels back within the threshold, except in cases where certain circumstances exist.[19]Other rules include a limit of 60 percent of GDP for general government debt, and the annual growth of primary expenditure[20] should not exceed long-term nominal GDP growth.The European Commission has also constructed an index of strength of fiscal rules for each rule in use. These are then used to construct a fiscal rule index for each Member State, presented in a time series from 1990 to 2013.[21]

The IMF also maintains a fiscal rules database that covers 9 of the 21 BCOP member countries (Armenia, Bulgaria, Croatia, Georgia, Kosovo, Montenegro, Romania, Russia, and Serbia).[22] This database includes country-specific information on fiscal rules in 89 countries from 1985 to end February 2015. The dataset covers four types of rules: budget balance rules, debt rules, expenditure rules and revenue rules applying to the central or general government. It also presents details on various characteristics of rules, such as their legal basis, coverage, escape clauses, as well as key supporting features such as independent monitoring bodies. From these characteristics the IMF derives a set of fiscal rules indices to construct an overall index for each of its member countries that assists to present analysis and trends.[23]

OECD Budget Practices and Procedures Survey contains a section on the application of fiscal rules.In 2012 the full survey was undertaken by 13 BCOP member countries,[24]including benchmarking practices against 33OECD countries who responded to the same survey. A summary of the 2012 results is provided below:

  • The percentage of OECD countries using fiscal rules has increased from 82% in 2007 to 94% in 2012 (i.e. 31 out of the possible 33 participating member countries).[25] At the time of the survey, only 7 of the 13 participating PEMPAL countries had fiscal rules.
  • Budget balance rules were more common than debt rules in both OECD and PEMPAL countries.
  • The number of fiscal rules used in OECD countries were 4-5 compared to 2-3 in PEMPAL countries. Most rules had a legal basis in legislation in both regions with OECD also having more under international treaty (driven by EU countries).
  • OECD countries use more enforcement mechanisms. Examples include excessive deficit procedures for EU countries; non-interest bearing deposits or fines; and presentation of correction proposals to the legislature.

It is proposed that the section on fiscal rules within the OECD Budget Practices and Procedures Survey, be issued (electronically) in the lead up to the BCOP plenary meeting to capture the current status on use of fiscal rules and toensure PEMPAL has more recent and complete information on its 21 member countries.The results of this informal survey will be shared during the meeting to facilitate benchmarking and networking between countries.

The OECD Survey examines five aspects of fiscal rules, namely:

  • the type of fiscal rules adopted: whether measured against expenditure, budget balance, debt or revenue;
  • the design of fiscal rules applied: what the fiscal rule targets and relates to for example cyclicality and GDP;
  • the legal basis of fiscal rules: whether established in primary law (i.e. the constitution or legislation) or political commitment / agreement between the governing coalition;
  • the duration of fiscal rules: whether established for a temporary period of time or on a permanent basis; and
  • the enforcement procedures in cases of non-compliance: which type of correction and accountability mechanisms are in place.

Meeting Objectives and Format

The key objectives of the meeting on ‘fiscal rules for effective and sustainable budgeting’ are to:

  • Share PEMPAL and international approaches on the use of fiscal rules, their impact and lessons learnt.
  • Provide the opportunity for BCOP member countries to exchange experiences and discuss possible approaches and options to using fiscal rules in the context of discussion groups. [26]

The PEMPAL meeting will primarily cover rules applying at the supranational[27] and national levelsthat capture a large share of central government public finances.

The BCOP Executive Committee has suggested that Russian Federation, Albania and Belarus be the PEMPAL country case studies covered in the meeting. The Russian Federation has offered to share its approach to fiscal rules in the context of developing long-term budgetary forecasts and reflect how these forecasts are prepared in the context of budget sustainability. Albania has also offered to share its experience in incorporating fiscal rules into its budget law and the results of its visits to other countries to determine the feasibility of establishing a fiscal council to monitor these rules. Belarus, as Host County, would also like to share its recently completed public financial management strategy which underpins its efforts to ensure effective and sustainable budgeting. International organizations such as the World Bank, OECD and IMF will also participate to provide lessons from the research and work with their member countries.

Two international country case studies have been confirmed in the agenda, Sweden and Latvia.In the early 1990s, Swedenfaced a severe budget crisis but has since made a remarkable turnaround. The principles of fiscal policy that have underpinned Sweden’s fiscal consolidation have included several elements including a fiscal rule requiring a budget surplus equal to 1 percent of GDP on average over the business cycle, and a Fiscal Policy Council.[28]Latvia emphasizes sustainability in its fiscal policy objectives. Public financial resources are being shifted not only to current measures for improving a quality of life, but also are being planned and allocated in a manner, providing conditions for the state to raise a quality of life also in subsequent 10 and 50 years. This has included the introduction of a Fiscal Discipline Law, numerical fiscal rules, and Fiscal Council.[29] Changes to the pension system to ensure sustainability of finances, have also been introduced.

The meeting format was designed based on feedback from participants in previous post-event surveys. It is proposed that the event lasts for three days, comprising two and a half days for the meeting and a half-day for a cultural tour (to be hosted by the Ministry of Finance, Belarus). A further half-day is planned for a face-to-face meeting of the budget literacy working group which will meet to discuss citizen budgets (refer to agenda at Attachment 2). The BCOP Executive Committee will moderate all sessions, which includes introducing speakers, providing information on their background, and managing panel question sessions.[30] In more detail the format is as follows: