Time for Fiscal Rules?

Should governments set rules to constrain the size of government borrowing on an annual basis or government debt accumulated over time? Pierre Yared discusses the question in "Rising Government Debt: Causes and Solutions for a Decades-Old Trend," in the Spring 2019 issue of the Journal of Economic Perspectives.

There's really no economic case to be made for the plain-vanilla rule that national governments should balance their budget every year. During a recession, for example, tax revenues will fall as income falls, and government spending on  programs like unemployment insurance, Medicaid, and food stamps will rise. If in the face of these forces the government wanted to keep a balanced budget during a recession, it would thus need to find ways to raise its tax revenues and cut other spending even while the economy is weak. A more sensible strategy is to find ways for these fiscal "automatic stabilizers" to function more strongly.

But the foolishness of a simplistic rule to balance the budget every year doesn't mean that no rules at all can work. But as Yared writes (citations omitted):  "Thus, governments across the world have adopted fiscal rules�such as mandated deficit, spending, or revenue limits�to curtail future increases in government debt. In 2015, 92 countries had fiscal rules in place, a dramatic increase from
1990, when only seven countries had them."

The form of these rules varies across countries. A basic lesson seems to be that all fiscal rules are imperfect, and can be gamed or avoided if a government wishes to do so, but also that well-designed rules--even with looseness and imperfections--do offer some constraints and limits that can hold down the amount of government borrowing.

Yared mentions an IMF study by Luc Eyraud, Xavier Debrun, Andrew Hodge, Victor Duarte Lledo, and Catherine A Pattillo called "Second-Generation Fiscal Rules : Balancing Simplicity, Flexibility, and Enforceability" (IMF Staff Discussion Note, SDN/18/04,  April 13, 2018).  They sum up the situation with fiscal rules in this way:

By improving fiscal performance, well-designed rules help build and preserve fiscal space while allowing its sensible use. Good rules encourage building buffers in good times and allow fiscal policy to support the economy in bad times. This implies letting automatic stabilizers operate symmetrically over the cycle and including escape clauses that allow discretionary fiscal support when needed. By supporting a credible commitment to fiscal sustainability, rules can also create space in the budget for financing growth-enhancing reforms and inclusive policies. 

To be effective, fiscal rules should have three main properties�simplicity, flexibility, and enforceability. These three properties are very difficult to achieve simultaneously, and past reforms have struggled to find the right balance. In the past decade, �second-generation� reforms have expanded the flexibility provisions (for example, with new escape clauses) and improved enforceability (by introducing independent fiscal councils, broader sanctions, and correction mechanisms). However, these innovations as well as the incremental nature of the reforms have made the systems of rules more complicated to operate, while compliance has not improved. ... 

This paper presents new evidence that well-designed rules are indeed effective in constraining excessive deficits. Country experiences show that successful rules generally have broad institutional coverage, are tightly linked to fiscal sustainability objectives, are easy to understand and monitor, and support countercyclical fiscal policy. Supporting institutions, like fiscal councils, are also important. In contrast, rules that are poorly designed and do not align well with country circumstances can be counterproductive. Novel empirical research finds that fiscal rules can reduce the deficit bias even when they are not complied with.

In his essay in JEP, Yared offers some more detailed insights. In some ways, the key issue isn't the fiscal rule you set, but rather what consequences will arise if the rule is broken. Here's Yared:

There are several issues to take into account when considering punishments for breaking fiscal rules. First, whether or not rules have been broken might be unclear. There are numerous examples of how governments can use creative accounting to circumvent rules. Frankel and Schreger (2013) describe how euro-area governments use overoptimistic growth forecasts to comply with fiscal rules. Many US states compensate government employees with future pension payments, which increases off-balance-sheet entitlement liabilities not subject to fiscal rules (Bouton, Lizzeri, and Persico 2016). In 2016, President Dilma Rousseff of Brazil was impeached for illegally using state-run banks to pay government expenses and bypass the fiscal responsibility law (Leahy 2016). Given this transparency problem, many countries have established independent fiscal councils to assess and monitor compliance with fiscal rules (Debrun et al. 2013).

A second issue to consider is the credibility of punishments. As an example, the Excessive Deficit Procedure against France and Germany in 2003 was stalled by disagreement between the European Commission and the European Council; consequently, French and German deficits persisted without penalty  ...

A third issue is the response of the private sector to the violation of rules, which can also serve as a form of punishment. For example, Eyraud, Debrun, Hodge, Lled�, and Pattillo (2018) [in the IMF study mentioned above] find that the violation of fiscal rules is associated with a significant increase in interest rate spreads for sovereign borrowing. Such an increase in financing costs immediately penalizes a government for breaching a rule. ...

Many governments� fiscal rules feature an escape clause that allows violating the rule under exceptional circumstances (Lled� et al. 2017). Triggering an escape clause typically involves a review process, which culminates in a final decision by an independent fiscal council, a legislature, or citizens via a referendum. In Switzerland, for example, the government can deviate from a fiscal rule with a legislative supermajority in the cases of natural disaster, severe recession, or changes in accounting method. The cost of triggering an escape clause deters governments from using them too frequently. Moreover, because these costs largely involve a facilitation of information gathering to promote efficient fiscal policy, escape clauses are useful even in the presence of perfect rule enforcement.

Again, a theme that emerges is that a government which is serious about a fiscal rule will want to set up procedures to be followed when that rule is being broken. In turn, those procedures should be high-profile at least in a publicity sense, so that the decision to break the fiscal rule must be explained, justified, and evaluated by an independent commission.

Another issue Yared mentions is that a fiscal rule can be designed with different categories: instrument-based rules that focus on specific categories of  spending or taxes, or overall target-based rules. He writes:

In practice, fiscal rules can constrain different instruments of policy, such as specific categories of government spending or tax rates. Different instruments may call for different thresholds ... For instance, due to volatile geopolitical conditions, military spending needs may be less forecastable than other spending needs, and may thus demand more flexibility. Capital spending is another category where allowing increased flexibility may be optimal, as the benefits of capital spending accrue well into the future and are thus subject to a less-severe present bias. Thus, many countries have �golden rules,� which limit spending net of a government�s capital expenditure. ... Overall, the evidence [suggests that rules that distinguish across categories are indeed associated with better fiscal and macroeconomic outcomes (for discussion, see Eyraud, Lled�, Dudine, and Peralta 2018). Moreover, it can be optimal to set multiple layers of rules, for example specifying a fiscal threshold for individual categories of taxes and spending as well as on the total level of taxes and spending in the form of a (forecasted) deficit rule.  

Ultimately, Yared argued for the benefits of a hybrid rule, "which allows for an instrument threshold that is relaxed whenever a target threshold is satisfied." 

In short, practical fiscal rules are quite possible, at least according the 90-plus countries that have them. And research suggests that such rule do constrain government borrowing, even given that they are going to be broken from time to time. But simple-minded fiscal rules like the US government "debt ceiling" will be essentially pointless, except for connoisseurs of short-term political dramas. Meaningful fiscal rules will not be simple, and will need to pay detailed attention not just to the overall goal, but to the practical issues of how much flexibility should surround the goal and what consequences will result when government borrowing that break through even a flexible rule.