SUERF: Choosing the European fiscal rule

26 January 2022

We evaluate the properties of two fiscal rules – the structural balance rule and the expenditure growth rule. Having just the expenditure growth rule tends to yield more stable macroeconomic outcomes, but more volatile public finances, as compared to having only the structural balance rule.

• The expenditure growth rule facilitates economic stability but raises public debt volatility.
• An effective way to reduce public debt volatility is raising the strength of the public debt correction term.
• Higher public debt levels make the economy more volatile.
• The golden rule helps protect public investment but incentivizes the governments to misclassify its expenditure.
• After a build-up of debt, the expenditure growth rule tends to postpone fiscal consolidation to future periods.
• Accounting for interest payments in fiscal rules strengthens the co-movement between monetary and fiscal policies but may turn vicious in typical business-cycle frequencies.
• The household welfare is 4–5% higher under the expenditure growth rule than under the structural balance rule.

The European Union (EU) fiscal framework has become overly complex

In addition, the EU fiscal framework has failed to reduce public debt and avoid fiscal procyclicality (European Fiscal Board, 2019).

• The EU fiscal framework has been subject to several reforms, each adding new provisions.
• Currently, there are two operational fiscal rules – the structural balance and the expenditure growth rule.
• The structural balance rule sets limits to the public deficit-to-GDP ratio, adjusted by the output gap.
• The expenditure growth rule stipulates that the public expenditure growth should be in line with long-term potential output growth; public expenditure is subject to exclusion of items out of the control of the government, such as interest payments.
• The two fiscal rules may be in conflict with each other – one rule may allow for more spending, while the other may suggest fiscal consolidation.
• Having two fiscal rules gives rise to the possibility of cherry-picking, a state in which a member state can choose the least stringent fiscal rule.

These issues have triggered discussions on revisiting the EU fiscal framework and simplifying the rules, suggesting having just one operational rule. The literature has identified that the expenditure growth rule may be the preferred fiscal rule (Benassy-Quere et al., 2018; Claeys et al., 2016; Darvas et al., 2018; German Council of Economic Experts, 2017; European Fiscal Board, 2019).

• The structural balance measure can be subject to large ex post revisions which may lead to misguided policy advice (Kamps et al., 2014; Coibion et al., 2017; Kamps and Leiner-Killinger, 2019).
• On the contrary, the expenditure growth rule
  • helps creating buffers in good times, thus allowing automatic stabilizers to operate (Eyraud et al., 2018);
  • improves fiscal discipline, as it is most directly connected to instruments that the policymakers effectively control (Cordes et al., 2015);
  • raises compliance rate (IMF, 2014);
  • is easier to monitor, predict and communicate.

It is easier to communicate to the public that the government expenditure will grow in line with the long-term potential growth rate than explain the output gap and its revisions – the construct entering the structural balance rule.

Yet, a downside of the expenditure growth rule is its dependence on the initial level of public expenditure and its weaker relation to debt stability (among others, due to expenditure exclusions); consequently, having an explicit fiscal medium-term anchor, that is, a government debt target, is recommended (Symansky et al., 2008).

Therefore, several proposals (Benassy-Quere et al., 2018; Claeys et al., 2016; Darvas et al., 2018; German Council of Economic Experts, 2017; European Fiscal Board, 2019) suggest an EU fiscal framework based on a reference value for public debt with an operational annual limit for the public expenditure growth. To improve the quality of public finances and safeguard public investment, the European Fiscal Board (2019) proposes a golden rule by excluding growth-enhancing expenditure from fiscal rules....

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