Economic analysis from the European Commission s Directorate-General for Economic and Financial Affairs

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1 Economic analysis from the European Commission s Directorate-General for Economic and Financial Affairs Volume 1, Issue 5 Date: ECFIN COUNTRY FOCUS Highlights in this issue: Budgetary strategies based on targets are pertinent, but require strict adherence to set objectives Enforceability and public finance reforms are key requirements Expenditure rules à la française: an assessment after five years By Laurent Moulin* Summary In 1998, France introduced a new budgetary strategy based on setting multi-annual objectives for increases in real general. This strategy, which helps forming expectations and enhances the transparency of the budgetary framework, is economically pertinent. However, in the first five years of its implementation, the strategy did not lead to the expected results. Initial targets were missed by a large margin, and the objective of consolidating public finances through a structural decline in the -to-gdp ratio was not achieved. Identifying the causes for the difficulties of the French budgetary strategy is a necessary prerequisite for possible improvements. The analysis of recent developments allows isolating two main causes. First, the French budgetary rule is relatively weak, in the sense that it is not enforceable, and, second, the ambitious targets were not supported by adequate public finance reforms. Recent developments have, however, triggered some hopes that objectives will be better respected in the next few years. In 1998, France introduced a budgetary strategy based on norms Each year, the French authorities set a multi-annual target Since 1998, the French medium-term budgetary strategy has been based on the setting of a target for the cumulated increase in real over a three-year period. In practice, real has been planned to increase more slowly than potential real GDP. The implied projected decline in the -to- GDP ratio was supposed to trigger a reduction in the cyclically-adjusted deficit, and, at the same time, allow a reduction in the tax burden. The target is set for general, deflated by the consumer price index (excluding tobacco). There is no constraint on the composition of. In particular, the targets do not distinguish between current and capital, and cyclically-sensitive items are included in the aggregate 1. Every year, a new target is set for a three-year period. The periods overlap so that targets set for a given year can be modified. * Directorate for the Economies of the Member States. The views expressed in the ECFIN Country Focus belong to the authors only and do not necessarily correspond to those of the Directorate-General for Economic and Financial Affairs or the European Commission.

2 Successive targets for the increase in real general % Target set in 1998 for % cumulated Target set in 1999 for % cumulated Target set in 2000 for % cumulated Target set in 2001 for % cumulated Target set in 2002 for % cumulated Target set in 2003 for % cumulated Observed 1.5% 2.1% 3.2% 2.1% 1.2% Source: Stability programme of France and successive updates; Autumn 2003 Commission forecast for The economic literature stresses that budgetary strategies based on targets have specific advantages Budgetary strategies based on targets have clear advantages The economic literature stresses the advantages of budgetary rules in forming expectations and enhancing the transparency of the budgetary framework. Budgetary rules based on the setting of spending limits have, in addition, the following positive aspects: As argued by Mills and Quinet (2002), they are commitments by the on those parts of public finances that are under its direct control; they usually cause less measurement and surveillance problems, and they allow automatic stabilisers to work fully on the revenue side. Moreover, as also stressed by Brunila (2002), rules help tackling deficit bias by highlighting possible spending overruns and thereby helping to address the principal source of the fiscal profligacy: political and institutional temptation to raise in good times. Finally, if adequately set and enforced, rules make tax reductions more credible by making economic agents anticipate that they will be permanent. This is one of the channels triggering possible non-keynesian effects which would reduce the cost of fiscal consolidation. There are different ways to design rules. Targets can be set for overall general or exclude some categories (interest payments, unemployment benefits, capital ). Targeting total has the advantage of simplicity and transparency. However, it can induce a bias towards the reduction of less politically-sensitive spending categories, for example capital spending. The target can be defined in nominal or in real terms. A target defined in nominal terms is more simple and makes monitoring easier. It can also prove more helpful in stabilising the economy in case demand-pull inflation would emerge. On the other hand, a target set in real terms allows to take into account the impact of inflation on developments. Finally, there is the issue of the time span covered by the rule. It is generally considered that multi-annual spending rules are superior to annual rules, because the latter can be more easily circumvented by postponing s to the period immediately following the budget year. Ideally, in the context of multi-annual rules, deviations in one year should be compensated for the following years. By constraining growth in public spending, rules can contribute to respecting the objectives of the Stability and Growth Pact. However, they should not be considered as a substitute for rules based on debt and deficits. Complementarity between spending rules and the EMU fiscal framework requires that spending ECFIN Country Focus Volume 1, Issue 5 Page 2

3 targets are set taking into account developments in revenue. It is also worth noting that rules may be adequate as a national rule but their use in a multinational context appears problematic. Indeed, cross-country spillovers are less clearcut in the case of public spending and uniform spending rules would de facto impose homogeneous social preferences on heterogeneous countries. The economic literature also provides interesting criteria against which the quality of fiscal rules can be assessed Good fiscal rules fulfil a number of criteria The quality of rules can be examined in the light of the more general theoretical and empirical work on fiscal rules. Kopits and Symansky (1998) identify a number of desirable features against which the quality of fiscal rules can be assessed. According to these criteria, an ideal fiscal rule should be well defined, transparent, simple, flexible, adequate relative to the final goal, consistent with other policies, enforceable, and underpinned by adequate public finance reforms. There are obvious trade-offs between the various criteria. These trade-offs are notably influenced by way the rule is designed. For instance, a fiscal rule based on setting targets in terms of total general will be simple, but, as mentioned above, may be less adequate in economic terms. Implementation, ex-post assessment and correction mechanisms are key elements of a fiscal rule. Indeed, once a rule has been established, compliance has to be ensured. This idea is further developed by Inman (1996), who proposes four main criteria for compliance: timing for review, overriding, enforcement and amendment. For a fiscal rule to be effective there must be ex-post, not ex-ante, deficit accounting. In addition, a fiscal rule is considered strong when it cannot be overridden or temporarily suspended by a simple majority vote of Parliament. The ideas behind Inman s third criteria are that (1) good rules are enforced by an open and politically independent review panel or court (as opposed to a partisan body) and (2) when the fiscal rules are violated, there must be significant and enforceable sanctions. Finally, Inman stresses that when amending the rules is costly, sticking to the fiscal rules may be more attractive than trying to bend them. The following sections of this country focus examine the functioning of the French budgetary rule since it was introduced, and assess its quality on the basis of the criteria presented above. The initial targets were missed by a large margin Expenditure increased much faster than initially planned Five years after the new French budgetary strategy based on setting targets was introduced, a preliminary assessment can be made. The graph below shows that the objectives set in the past were not respected. The cumulated increase in real over the period reached 6.8%, as against 3.5% targeted in 1998; over the period , the increase reached 7.4%, as against 4.0% targeted in Yearly data show that increases were never consistent with respecting the targets. This was true both in good cyclical times (2000, 2001) and in bad times (2003). The overruns were large in the social security and the local sectors: between 1999 and 2002, annual real increases averaged 3.2% and 2.7% respectively, against about 1.5% targeted for these sectors in 1998 in the stability programme. Expenditure targets were generally respected by the State, with the notable exception of the election year Targets set in the initial stability programme vs. outcomes Cumulated increase in real between 1999 and 2002 Target (ESA 79) Outcome (ESA 95) State Social security sector Local sector Source: Stability programme of France and subsequent updates ECFIN Country Focus Volume 1, Issue 5 Page 3

4 Half of the slippage was incorporated in the Finance Laws themselves The introduction of the budgetary strategy based on targets did not lead to the expected slowdown in The non-respect of targets has two different origins. First, it reflects the fact that objectives set in the Finance Laws were not always consistent with the previously fixed multi-annual targets. This factor contributed to about half of the total deviation in real s compared to the initial plans set in the stability programmes. The second reason for the non-respect of targets is the difficulty the authorities have faced in keeping in line with the targets set in the Finance Laws. Expenditure plans: from plans... to plans... to outcomes Cumulated increase in real general s over Initial multi-annual target set in 1999 Increase planned in Budgets Outcome Cumulated increase in real general s over Initial multi-annual target set in 2000 Increase planned in Budgets Outcome 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Source: Stability programmes, Finance Laws 2000 to 2003, national accounts (Insee) When placing the developments of the last few years in a historical perspective, it appears that the introduction of the strategy based on norms has, so far, not produced visible effects. Indeed, has even been slightly more dynamic since the introduction of the rule than in the immediate post- Maastricht era (the only structural break that is visible in the series occurred just after the ratification of the Maastricht Treaty and the start of stage two of EMU). 6% 5% Real general s did not decelerate Pre-Maastricht era Consolidation period Expenditure targets 4% 3% 2% 1% 0% annual % change Average over the period Source: national accounts (Insee) When placing the developments of the last few years in a historical perspective, it appears that the introduction of the strategy based on norms has, so far, not produced visible effects. Indeed, has even been slightly more dynamic since the introduction of the rule than in the immediate post- Maastricht era (the only structural break that is visible in the series occurred just after the ratification of the Maastricht Treaty and the start of stage two of EMU). Between 1999 and 2003, real increased in line with potential real GDP, estimated at about 2.2 percent a year. Based on this evidence, the deterioration in the cyclically-adjusted deficit observed over this period (about 1½ percentage point of GDP) cannot be attributed to an increase in the structural -to-gdp ratio. However, from 1999 onwards, the setting of ambitious objectives allowed the authorities to envisage large tax cuts. It is the combination of the nonrespect of targets and the adherence to tax alleviation plans that ECFIN Country Focus Volume 1, Issue 5 Page 4

5 triggered the significant deterioration in the cyclically-adjusted balance observed between 1999 and % Slippage in ependiture contributed to the increase in the general deficit 54% 53% 52% 51% Deficit to GDP ratio which would have resulted from adherence to plans 1.8 % of GDP 50% Observed to GDP ratio Expenditure to GDP ratio which would have resulted from adherence to plans Revenue to GDP ratio Source: Stability programmes, national accounts (Insee) The analysis of the reasons for the failure The French budgetary rule performs relatively well with regard to most of the criteria of ideal fiscal rules proposed by Kopits and Symansky. In particular, the rule is relatively well defined, transparent, simple and flexible. The rule can also be considered to be consistent with other macroeconomic policies and adequate relative to the final goal set in the initial stability programme (ensuring a steady decline in the structural deficit). However, the French budgetary rule is not enforceable; it performs poorly with regard to Inman s criteria. Moreover, it was not, in the past, supported by adequate public finances reforms: Reasons for the non respect of rules are strongly linked to their weak institutional status and to the absence of public finance reforms supporting the ambitious objectives The French budgetary rule is not enforceable, and ex-post assessment mechanisms are weak. There is no national independent authority for monitoring compliance with the targets and, if necessary, ensuring enforcement of the rule. In addition, the multi-annual targets can be overridden by a simple vote in Parliament, and the is not obliged to justify possible departures from the multi-annual targets. Finally, no rule or mechanism ensuring compensation of overspending across years exists. the targets were not supported by efficient public finances reforms. Indeed, as stated by Kopits and Symansky, fiscal rules have to be viewed as a catalyst for fiscal reforms that would be necessary anyway to ensure sustainability. On average, targets set so far were consistent with a projected decline in the structural to GDP ratio by 2 percentage points over a 3-year period. In a context where strong pressures rather tend to push the share of in GDP upward, achieving such objectives required the implementation of bold public finance reforms. In the period under review, there was no support from such reforms in keeping in line with plans 2. These features of the French fiscal rule contributed to limiting its effectiveness as an instrument for controlling public finance developments. suggests proposals for improvements Enforceability of the objectives needs to be strengthened Making multi-annual objectives more binding would constitute a major improvement. The Government would have to explain and justify (i) any inconsistency between targets set in the Finance Laws and the previously set medium-term plans and (ii) any deviation in the budgetary execution from the target set in the Finance Laws. This would give more visibility to multiannual objectives and make the more accountable for their respect. Enforceability could also be improved by the implementation of a mechanism ECFIN Country Focus Volume 1, Issue 5 Page 5

6 ensuring automatic compensation across years of possible slippage in a given year. On 10 February 2004, when giving its Opinion on the 2003 update on the stability programme, the EU Council recommended the implementation of such a mechanism. and setting new objectives has to be accompanied by clear commitments or reform plans It is also crucial that any new multi-annual projection for is made together with the presentation of plans or intentions for structural reforms aimed at achieving the projected decline in the -to-gdp ratio. Ideally, these reforms should be defined when the targets are set. In this respect, progress was observed recently: the target set in the 2003 update of the stability programme for the period was accompanied by detailed intentions for future reforms aimed at ensuring the respect of the targets 3. In this context, the French authorities are currently designing a comprehensive reform of the health care system, in order to significantly curb the dynamics of spending in this sector. This notwithstanding, when looking at the practices in other EU countries, it appears that (i) most of existing national rules are based on political commitments rather than legislation and (ii) the implementation and enforcement mechanisms are generally weak: sanctions are generally absent or economically insignificant. This explains partly why in many cases discretionary adjustments to the rules have taken place when the original ceilings started to act as a constraint. However, in some cases (Denmark, the Netherlands, Sweden), the rules were respected and seem to have had a restraining impact on (see table in annex). Interestingly, in two of these three countries some automatic action is foreseen by Law in case of non compliance with the rule. BE DK DE ES IE IT NL FI SE Annex public consumption and local s Non financial of central total General primary General total primary Annual real Annual nominal Nominal ceilings Annual nominal Nominal ceilings Real ceilings Real ceilings Nominal ceilings Annual Indefinite The features and implementation of rules within Member States Definition of Definition Action in case of Degree of Time span target target non compliance success Federal Annual real primary Mixed Recommendations by a committee Legislation frozen until new legislation makes funding available Offsetting of overruns The shall prepare a proposal for correction Source: European Commission (2003), Public Finances in EMU 2003 Relatively high Mixed Too early to assess (introduced in 2003) Rule abandoned Too early to assess (introduced at the end of year) High Mixed High ECFIN Country Focus Volume 1, Issue 5 Page 6

7 References Inman, R.P. (1996), Do balanced budget rules work? U.S. experience and possible lessons for the EMU, NBER Working Paper Series, 5838 Kopits G., S. Symansky (1998) Fiscal Policy Rules, IMF Occasional Paper, 162 Mills P. and A. Quinet (2002), How to Allow the Automatic Stabilisers to Play Fully? A Policy-Maker s Guide for EMU Countries, in M. Buti, J. von Hagen and C. Martinez-Mongay (eds)., The behaviour of fiscal authorities stabilisation, growth and institutions, pp Brunila, A. (2002), Fiscal Policy: Coordination, Discipline and Stabilisation, paper prepared for the Group of Economic Analysis of the European Commission European Commission (2003), Public Finances in EMU 2003, European Economy, Reports and Studies, 3. European Commission (2003), Update of the stability programme of France ( ) - an assessment Ministère de l Économie et des Finances, France, Programme pluriannuel de finances publiques A decomposition of the objective by sub-sectors of general is provided (central, local authorities and social security, divided by branches). 2 In Summer 2003, the French Parliament adopted a comprehensive reform of the pension system. The reform will generate large savings in the long term, but its impact on short term developments in will be marginal. 3 In particular, reforms were announced in order to secure the attainment of objectives in the State sector, and in order to curb decisively the spending dynamics in the health sector. The ECFIN Country Focus provides concise analysis of a policy-relevant economic question for one or more of the EU Member States. Chief Editor: Marco Buti, Director of the Directorate for the Economies of the Member States. Coordinating Committee: Ronald Albers, John Macdonald, Charlotte Van Hooydonk Layout: Vittorio Gargaro, Karl Gradinger, John Macdonald ECFIN-CountryFocus@cec.eu.int Website: ECFIN Country Focus Volume 1, Issue 5 Page 7

EXPENDITURE RULES. Database

EXPENDITURE RULES. Database EXPENDITURE RULES Fiscal (or budgetary) rules regulate the development of public budget deficits and surpluses (see DICE Report 2/2004), without explicit reference to s or revenues. The revenue side is