Embracing Fiscal Rules for a New Age

With Fiscal Rules being a less explored part of fiscal policy, this article attempts to construct a rationale for why more nations should embrace this framework for better economic performance and prioritise long-term growth over short term political benefits.

[Pavan Sundar is a first year Bachelor of Economics student at Monash Clayton with a passion for sharing economic knowledge into the world. He joined ESSA in Semester 2, 2023 and has since been an active member, contributing to the Publications Team since 2024 as a Writer. He enjoys having long conversations, economics surfing and a bit of Student Theatre.]

When John Keynes developed the theory that governments must play a key role in ensuring economic stability in the early 20th century, it was riddled with contradictions from the conventional economic thinking of an ‘invisible hand’ operating the free markets. But today, it has become the gold standard of fiscal governance globally. Expanding this thinking is the idea of Constitutional Economic Theory, that is the study of the conditions and choices that exist within the constraints of legal frameworks such as a political constitution.

A key idea that is often discussed in Constitutional Economics is creating and utilising Fiscal Rules as a framework to influence the budget making process of a country. This process usually involves mass consultations, and discussions within governmental bodies to determine its appropriations or how much they can spend each year. These are often influenced by the time-inconsistency problem, the idea that the policy preferences and priorities of governments change over time depending on political priorities.

Fiscal Rules are norms that are used to regulate the budget process and act as a stopgap to the time-inconsistency problem by becoming a tool for transparency. There are broadly two variants of Fiscal Rules, Numeric and Procedural. While numerical deals with the quantitative constraints on fiscal policy such as balancing budgets (that is income equals expenses), expenditure caps, targets for fiscal variables, borrowing and restriction on debt issue-based regulation, the procedural aspects of fiscal rules deal with the process, on how decisions of income and spending are made [1].

Enshrining fiscal rules into law allows for governments to establish routines and standards which enhance their credibility and long-term macroeconomic stability. It ensures adequate information for accountability over government expenditures, and minimises negative externalities within an international framework. A quality fiscal rules framework encourages fiscal prudence and should attempt to cover the scope and structure of the budget. It should be able to calendarise the production of budgets, deal with supplementary budgets, that is, procedures to fund unexpected spending and emergencies, and enhance reporting requirements. [2]

Another key advantage of using fiscal rules to devise budgets is the integration of intergenerational redistribution of fiscal deficits and borrowings. This then reduces the harm of fiscal illusion, the idea that voters do not completely realise the trade-off between current spending and future burdens in favour of short-term advantages and benefits. A simple example to demonstrate this is when politicians often promise for lower taxes and ‘freebies’, at the cost of higher borrowing, which slows down long-term economic growth, due to repayment obligations of the borrowed debt. Instituting fiscal rules could prevent just that.

Ideal fiscal rules will also resolve the free-rider problem within a currency area and use responsible fiscal governance as an advantage to protect currency and access to capital markets.

Fiscal Rules also provide an objective framework for the public to assess governmental performance, thus incentivising political agents to act in favour of long-term fiscal prudence. Some of the key beneficiaries of using fiscal rules as a policy tool have been analysed by a comparative study by the OECD. This study shows that both advanced nations such as Germany, and emerging economies such as India and Brazil have used fiscal rules as a sign of macroeconomic stability, helping businesses and individuals predict the nature of policies and thus show greater confidence for companies to conduct large-scale investments [2].

Nations such as Singapore and Hong Kong have also particularly benefited economically from borrowing-based fiscal rules, such as restricting the ability of one government to borrow from the debt reserves accumulated by its predecessors (Singapore) or the requirement of balanced budgets and constitutional enshrinement of its low tax policy (Hong Kong).

Another study by the IMF has found that fiscal transparency through use of fiscal rules have helped nations enhance their credit ratings, control over corruption and other indirect factors that influence the ability to finance large-scale developmental projects and economic growth [3]. There is also evidence that enshrining these rules in constitutional frameworks has helped improve consumer confidence over property rights, which in turn serves as a driver for greater investment.

These studies however do not mean that countries choose to implement them. Fiscal Rules have often been criticised for not allowing politicians freedom to spend their monies in any fashion of their choice, and in many cases, especially when they are created as a response to the demands of the IMF or the World Bank. Their utility is also criticised on theoretical grounds that neither traditional macroeconomic theory nor public finance is rooted in such rules.

Another criticism often brought up is the extension of decision lags due to the implementation of these rules and their rigidities, which may not have researched estimated effects yet. To counter these criticisms, the literature and practice around fiscal rules have evolved to promote more investment, by encouraging governments to think beyond self-financing large developmental projects. Fiscal Rules allow for streamlined decision-making among governmental departments, and its inclusion within the Constitutional Economics theory has provided greater legitimacy within economic theory than when it stood as a budget construct.

Fiscal Rules have shown to be an empowering practice, a policy tool which can be used by governments to promote investment, increase its economic output, and provide a greater standard-of-living for its citizens [3], and thus we urge more nations to embrace Fiscal Rules for a new age of development and global prosperity.

References

1. Aras, Osman Nuri and Mustafa Öztürk. “Constitutional Economics, Fiscal Policy Rules, and The Case of Turkey.” International Journal of Social Sciences and Humanity Studies, vol. 3, no. 2, 2011, pp. 399-410. Munich Personal RePEc Archive. https://mpra.ub.uni-muenchen.de/id/eprint/81856
2. Constitutions in OECD Countries: A Comparative Study. Organisation for Economic Co-operation and Development (OECD), 2022, https://doi.org/10.1787/ccb3ca1b-en.
3. Fiscal Transparency and Economic Outcomes. International Monetary Fund (IMF), 2005, https://www.imf.org/external/pubs/ft/wp/2005/wp05225.pdf