Should governments be free to set their fiscal policy as they see fit, or should their decisions be constrained by numerical fiscal rules, such as European Union rules that the debt should be less than 60 percent of GDP and the deficit less than 3 percent of GDP? And if governments must be constrained, what are the rules that should constrain them?
These questions are currently crucial in the Western Balkans. The region’s public debt rose sharply during the global financial crisis– from 26% of GDP in 2008 to a peak of 54% in 2016 – and bringing it back to safer levels has been a priority ever since. These countries also have ambitions to join the European Union (EU), which will require them to have healthy public finances and, ultimately, to adopt the EU system of fiscal rules.
Many approaches to fiscal rules currently exist in the six Western Balkan countries. Five of the six economies have fiscal rules, although the nature of these rules varies considerably. Debt limits range from 40 to 60 percent of GDP. Some countries limit the total budget deficit; others limit the budget deficit excluding public investment or the budget deficit excluding interest. Serbia has a deficit limit determined by a mathematical formula that takes into consideration its potential growth. And North Macedonia has no fiscal rules, although it enforces fiscal targets.
The diversity of approaches is understandable as circumstances vary between countries. Half of the Western Balkan countries (Albania, Montenegro, Serbia) face high and growing public debt, while others (Kosovo, Bosnia and Herzegovina, North Macedonia) have low to moderate debts. There are also significant differences in countries’ monetary and exchange rate regimes, with implications for fiscal policy. The ideal fiscal policy would be discretionary, able to respond to changing circumstances. This would be countercyclical, generating surpluses in good years and deficits in others. But discretion is rarely exercised prudently, and it often leads to permanent deficits and unmanageable debt. Maybe rules are better than discretion. But can the rules work if a government really wants to spend but not tax? If the rules become inconvenient, what’s to stop the government from repealing or ignoring them? In the Western Balkans, as in other regions, self-imposed fiscal rules have been broken almost as often as they have been respected.
It is difficult to obtain reliable empirical answers to questions about fiscal rules. On average, countries with fiscal rules have lower deficits than countries without them. But as is often the case in nationwide empirical work, it’s unclear why. For example, countries with a culture of fiscal prudence might choose both to run small deficits and adopt fiscal rules to express prudence.
Recent evidence suggests that fiscal rules reduce deficits in countries that traditionally have large deficits but increase them in countries that have small deficits— perhaps because the limits of rules can act like magnets. A rule that a deficit cannot exceed 3 percent of GDP can be interpreted, despite the intentions of its proponents, to mean that a deficit of 3 percent of GDP is normal.
At the World Bank, we reviewed the fiscal rules in force in the region and also conducted an online survey to assess public understanding of these rules. The analysis suggests compliance on average just over half the time – which isn’t great, but probably not much different from the experience of many other regions. However, reducing debt to prudent levels will require more than simply complying with the deficit rule. Albania would need to run a surplus of 0.8% of GDP each year to meet its debt target of 45% of GDP by 2025, much higher than it has achieved in recent years and much more than what the deficit rule requires. Serbia, which starts with a slightly lower debt, could reach a debt of 45 percent of GDP, and therefore comply with its debt rule, by running a constant deficit of 0.9 percent of GDP – a target slightly stricter than the average deficit of its formula-based rule. aims. Montenegro would have to run overall deficits well below the 3% of GDP allowed by its rule to comply with its 60% debt rule by 2025. Kosovo and Bosnia and Herzegovina are in a much better position due to their lower starting levels. debt (Figure 1).
Based on these and other findings, our current thinking is that fiscal rules policies should be guided by the following principles:
- These policies should make it easier to join the EU. This does not mean that countries must immediately adopt all EU budgetary rules; for now, the approach should be simpler, and debt limits or targets should probably be lower than 60 percent of EU GDP. Additionally, priority should be given to changes that will be beneficial even if adherence is delayed (a no-regrets approach).
- The limits of budgetary rules should not be confused with objectives. A deficit limit of 3 percent of GDP should not be confused with a guideline that a deficit of 3 percent is generally acceptable. The rules must be supplemented by objectives.
- And, perhaps most importantly, careful attention must be paid to the development of fiscal rules. politically effective. Since a national government can generally repeal or ignore a national fiscal rule that does not suit it, for that rule to be powerful, violations must be politically significant. This means that fiscal rules will work best if they are simple, widely understood, independently monitored, and have cross-party support.