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17 April 2023

CER's Tordoir: Five proposals for enforceable EU fiscal rules


A big fight over the rules will take place after the Commission translates its proposals into a draft regulation. The Commission is now under time pressure to deliver reform .. Unless a deal is made in the coming weeks, the process will spill into next year, with European elections in May 2024.

  • The EU’s fiscal rules, which guide and constrain member-states’ budget policies, are in desperate need of reform. They are too complicated, impose unrealistic demands on some countries, and lead to government overspending in economic booms and underspending in recessions. Unsurprisingly, countries barely comply with them.
  • The EU should learn from its enforcement mistakes. Technocratic bodies cannot enforce the rules on their own: only the European Commission with support from member-states has the legitimacy to press a democratically elected EU government to change its budget. Hard-wired numerical rules that are imposed on a ‘one size fits all’ basis are supposed to lead to strict enforcement, but they cannot account for big economic shifts or unforeseen crises – like Putin’s invasion of Ukraine, or the Covid pandemic.
  • The tension between rigid enforcement and economic reality has prompted the Commission to develop a flexible, but opaque, interpretation of the rulebook. At the same time, the political cost of sanctioning non-complying countries has time and again deterred the Commission and member-states from enforcing the rules.
  • After suspending the rules in the wake of the pandemic, member-states recently asked the European Commission for a reform proposal. The Commission’s first proposal, published in November 2022, had flaws, but rightly replaced hard-coded rules that applied to all member-states with multi-year debt-reduction plans individually negotiated with each member-state, enabling each country to take ownership of its own fiscal trajectory.
  • This has not pleased all member-states, though. Some capitals worry that the Commission will use its discretion to be soft on high-debt countries and want to maintain inflexible debt reduction targets. Germany has proposed that member-states with high debts cut debt-to-GDP ratios by 1 percentage point a year, which would be very difficult in periods of recession. That would once again tempt the European Commission to weaken enforcement, because some member-states would struggle to stick to the rules.
  • The Commission is right to propose tailored debt reduction plans for individual countries. It needs discretion to apply the fiscal framework in a way that keeps pace with a changing growth and inflation regime and critical EU challenges like climate change or military defence. But it cannot ask member-states to trust it blindly on enforcement. The way to solve the dilemma is coupling Commission discretion with stronger enforcement mechanisms to get member-states to follow debt reduction plans. The proposals of both the Commission and the German government fell short on enforcement.
  • This policy brief makes several proposals to make fiscal rule enforcement work better in the future:
    • First, member-states and the Commission should agree that a portion of future EU funds will be used as incentives for good fiscal behaviour. The new fiscal framework envisioned by the Commission tries to replicate the logic of the EU pandemic recovery fund by negotiating fiscal policy bilaterally with countries, rather than seeking to constrain them solely through rules. However, under the Commission’s proposal, EU funding will not be conditional on investment and reform, unlike the recovery fund, which will expire in 2026. The EU will launch its new budget in 2027: its pay-outs should be conditional on following the rules and some funds should be set aside as rewards for high-debt countries running sustainable fiscal policies.
    • Second, EU fiscal policy enforcement should closely align with national electoral cycles. The Commission initially proposed that each country should submit a four-year fiscal plan, extendable up to three years, to reduce public debt. That would be too lenient: there would be little incentive for a government with one year left to pursue reforms or public investment vigorously to avoid sanctions, or to obtain rewards from the EU institutions that only benefit the next government. Countries’ fiscal plans should cover a shorter period, such as two or three years, so that a government can reap the rewards of obeying the rules or frontloading key investments during its time in office, rather than letting its successor benefit from extra leeway or EU funds.
    • Third, the new framework should prevent dangerous fiscal policy errors rather than seeking to fine-tune policy. There should be a threshold before the Commission starts investigations. An example of such a threshold would be a fiscal balance that makes a falling debt ratio probable for the most indebted EU-countries. The Commission would only spring into action if a country was on the verge of enacting policies that would lead to increasing debt levels, and turn to enforcement if it assessed that a dangerous policy error was in the making.
    • Fourth, when a country’s budget is on the wrong track, the EU should redesign enforcement actions and fines so they act as a scale of escalating warning signals to bond markets, even if fines are unlikely to be imposed in practice. Making fines for less egregious fiscal mis-steps financially smaller would not reduce the political cost of imposing them – the EU has not imposed fines for non-compliance to date. But it would add more of a range of signals to bond markets about the Commission’s assessment of risks to debt sustainability. Past stand-offs between Brussels and capitals over fiscal policy have fed into higher government borrowing costs.
    • Fifth, technocratic institutions like independent fiscal watchdogs can play a significant role in evaluating policy and providing technical analysis, even if they cannot be enforcers. The British Office of Budget Responsibility is a strong model. But the quality of these institutions varies widely across Europe, and whether they gain proper independence, prominence and capacity depends on the political economy of each country. To help these institutions across the continent, the EU should provide a funding base to all national fiscal institutions if conditions of independence and quality are met...

 



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