Lesson 6

Fiscal policy: a new paradigm?

(A lesson of fiscal sceptisim)

(To whom does fiscal policy belong and whom does it really serve?)

                

   

George Washington

February 22, 1734 - December 14, 1799

"To contract new debts is not the way to pay old ones.„

source: George Washington, To James Welch, April 7, 1799.

A reminder of the basics …• „There ain't no such thing as a free lunch“ (who said that?)• There are no anonymous resources• There are no magic boxes …• Policy mistakes are often reproduced (past lessons are often

ignored – example: fiscal impulse to revitalize an economy is always paid hard by future generation, yet, governments keep having recourse to it …)

• The textbooks are right in stressing that the leading motive for policy makers is to get re-elected …

• It would be illusory to believe that a „win win“ solution to all can always be designed … in reality, it is more likely that the benefit of some will imply a loss (cost) to others (from the temporal or sectoral point of view, or both)

Where do we stand as of today?

• Economy in recession• Budget consolidation in progress• External commitments• Focus on financial markets• Confidence in government policies shaken• Political consensus on fiscal matters impossible

to achieve• Fiscal reforms (more or less) frozen• Ageing population

A reminder of examples for consideration …

Fiscal stimuli

• Purpose: compensate for output losses in crisis time• Assumption: governments should actively play the anticyclical card

of fiscal policies• Description of scheme: implemented either through automatic fiscal

stabilizers (what is that?) or discretionary fiscal policies• Who benefits: may have short-term cascade effects on many

segments of economy• Who suffers the costs: all taxpayers (current – via deficit - and future

– via debt), private sector (crowding-out and cost effect of public deficit/debt on private investment)

• Side effects: loss of credibility of fiscal policy, implied increased cost of borrowing and, most of all, future pro-cyclical feature of fiscal policy = fiscal consolidation in times of stagnation/recession (as seen currently)Question for discussion: is that a viable policy instrument? Discuss the short-term effects as opposed to the medium and long term ones …. Consider the current circumstances!

Fiscal policy is primarily about politics themselves …

ČSSD• It would not be wise to support the competitivity of economy by

reducing mechanically taxes• It is no longer possible to reduce further the tax quota• Progressive taxes are an efficient tool to stabilise public finance• Increase income tax rates and introduce two rates• Introduce FTT as a source to finance recovery and resolution in

the financial system• Stabilise the public (first) pension pillar by allocating resources

from the state budgetTOP 09• A balanced budget can be obtained only if fundamental reforms

are implemented on the expenditure side, especially those expenditure items which are mandatory

• Simplification of the tax base for direct taxes, simplification of the tax administration, eliminate special tax provisions

• A gradual introduction of a multi-pillar pension system

… however, in the real life, politicians may want (or have

to) adopt a different path

Government decisions since last elections:– Increases of VAT…– Increase of individual income tax rates for

people above a certain income threshold…– Increase social insurance for wealthier people

…

A bit of statistics: first, some good news (actually, are those

news really so good???)

The 2012 budget balance will be better than in 2011: 124 bn CZK (3,2% HDP)

5 years government bonds, selected countries, in %

Share of interest expenditure on general budget revenue (%)

-14-12-10

-8-6-4-20246

Finl

and

Den

mar

k

Swed

en

Luxe

mbo

urg

Bulg

aria

Cypr

us

Net

herl

ands

Ger

man

y

Aus

tria

Belg

ium

Slov

enia CR

Slov

akia

Port

ugal

Ital

y

Esto

nia

Lith

uani

a

Fran

ce

Pola

nd

Hun

gary

Spai

n

Latv

ia

Mal

ta UK

Rom

ania

Irel

and

Gre

ece

2008 2009EU27, 2008 EU27, 2009SGP, 3%

General Government DeficitsGeneral Government Deficits(in % of GDP, EDP methodology)(in % of GDP, EDP methodology)

Czech R: -2.1% of GDP in 2008 and -6.6% of GDP in 2009

Public debt in selected EU countries % of GDP

And the bad news …

Public finance balance 2005-2011 bil CZK

The Czech public debt

0

400

800

1 200

1 600

2 000

mld

. K

č

0

5

10

15

20

25

30

35

40

45

% H

DP

Státní dluh (mld. Kč)

Dluh vládního sektoru (% HDP)

Státní dluh (% HDP)

Public debt related expenditure 2000 - 2014

Financing the government: impact on client interest rates

Increase of mandatory expenditures becomes a major issue…

„Deficit bias“ what is that?

• Besides the economic cycle, it is the second major factor influencing the fluctuation of the fiscal position

• Institutional and political :– Institutional: imperfections of the budgetary process: drafting the

budget (forecasting the economy and budget revenue, assessing the needs and efficiency of various expenditure programs, imperfections in program implementation

– Systemic and structural rigidities, disconnecting the budget from the economic cycle

– Political factors: the limited capacity (willingness) of the political system (representation) to internalise the future consequences of the current fiscal decisions

– Inability of voters do appreciate the inter-temporal or intergenerational consequences of such policies

Links between the public and economic crises …

• Concept of privatisation of market economy benefits, as opposed to the socialization of costs …

• … connected to concepts of state interventionism, aimed at correcting market failures and reducing (through economic policies) the amplitude of economic cycles

• The (well justified) fear of collapse of the financial system and it´s repercussions on economy: taking over toxic assets, recapitalising banks etc

• Protecting depositors, avoiding domino effectsBUT: Let's consider the risks of moral hazard (mistreatment of risk, misallocation of capital, savings …): the current government action always implies risks of contributing to the next round of economic trouble: Do you agree?

Consequences …

• Procyclicality of budgets • Squeezing out private investment Explain• Inflationary pressures Explain• Investor's confidence Explain• Interest rates and exchange rate pressures Explain• Increased risk premium on government bonds: increased

costs of debt servicing (squeezing out government expenditure on purchase of good and service and financing of social transfers)

• Pressure on tax increases, tax optimisation (evasion or avoidance)

• Shortening of investment horizons• Social and political consequences

Credibility of government …

• „Loosing control“• How stable will the country be in the times to

come?• How will the government react in the future if the

fiscal situation was to deteriorate further/again? Will they adopt a restrictive attitude or will they rather let things happen?

• How can you plan for the future (investment, consumption…) if the government is so unpredictable? …

Intergenerational transfer and the „snow-ball“ effect

There are no escape avenues to avoid paying the bill for current fiscal expenditure:– Either the bill will be paid out of the current revenue,– Or it will have to be paid by future taxpayers

(squeezing out the capacity of the future fiscal policy to finance the future current expenditure)

• The higher the deficit and debt, the higher the costs of servicing … absolutely and relatively

• Reminder: If circumstances are not favourable, the debt may still be increasing even if the current budget is close to balance

Governments can no longer govern

• The budget is a key political instrument ...• Instead of financing their political priorities (promises),

governments are forced to focus efforts to budget consolidations (reforms)

• Differentials between political programmes are diminished

• Differentials between pre-election rhetoric (promises to voters) and the reality of post election actions are growing (it is hard to sell budget consolidation to voters and to get their support for that …) …

• … Weakening the trust of voters in politics (and politicians)

… what level of deficit/debt is sustainable?

There is no simple answer to that: it all depends on specific circumstances of a given country:

– Size of the economy– How deep (liquid) is the capital market– How open the economy is– Potential output– Nominal and real interest rates– Proportions of the cyclical and structural

components of the fiscal deficits– Demography etc ...

A reform is needed …

1. Deficits and debts are increasing2. Costs of servicing the debt are moving up3. The intergenerational distribution of deficit/debt costs

becomes a pressing issue4. The fiscal policy is no longer capable of playing an

anticyclical stabilisation role …5. … implying increased costs of monetary policy6. Negative impact on government credibility7. Perception of the country and the fiscal policy by financial

markets8. External context ...9. ... Euro adoption10. The capability of governments to implement their priorities

Why are institutional changes also relevant?

• According to government financial statistics, the central budget contains (only) about 70% of expenditure of the general budget (and 67% of the revenue)

• Other elements include budget of regional authorities, municipalities, state funds, health insurance companies, state agencies …

• Thus, if you want/need a fiscal reform, will you limit yourself only to the central budget or, alternatively, will you involve all components of the system (make them also „breath“ with the economy)?

• Part of the challenge is how much control does the central government want to exercise over the other elements (direct interference in their spending, or just establishing rules for their behaviour?)…

• Obviously, the less influence you exercise over them, the more burden on consolidating the general budget lies on the central state budget … is that fair?

• And so, a good fiscal reform need to include an institutional element

Reforms: basic assumptions

• Before 2009, the growth performance of our economy was quite impressive: the momentum for reforms was very favourable Explain why

• Now, the momentum is not good: the difficult economic circumstances make it hard to initiate and sustain durable reforms: it would be better to postpone the whole reform thing till circumstances improve (economic growth returns)

Is this assessment correct ???

The standard „keynesian“ approach

• Fiscal consolidation = reduction of deficit (increase of surplus

• Reduction of deficit = reductions of domestic demand• Reduction of domestic demand = reduction of output

growth dynamics

→ Consequently, fiscal consolidation and economic growth are negatively correlated (at least in the short run) → Therefore, it is possible go ahead with reforms only when economies are growing

Alternative approach

Reduction of deficits does not automatically imply a reduction of the aggregate domestic

Why? The reduction of public demand can be, in favourable circumstances, (more than) compensated by an increase

of the private demand• How?

– Improved confidence and expectations– Cost of servicing public debt reduce (lower risk premia) – Less restrictive monetary policy

• What matters: it is the credibility of the fiscal reforms (size and instruments – structure - of deficit reduction)

• structure of revenue vs. expenditure → Reforms may stimulate economic growth even in the

very short run

Empirical research by OECD, IMF …

• There is a direct correlation between the initial deficit size, the level of interest rates paid on debt and the extent and durability of fiscal consolidation

• The bigger and the longer the consolidation effort, the more there is accent on a reduction of the current budgetary expenditure

• However, the consolidation periods would, in most cases, last no more than 2 – 3 years

• The longer the consolidation period is, the smaller are annual improvements of the budget balance (reduction of deficits)

• It is apparent, that governments prefer easier steps and that a reform fatigue plays an important role by limiting the length of consolidation periods

Fiscal consolidation and economic growth• Reform measures on the expenditure side have a

more lasting effect …• … and improve the business environment (positive

growth impact) – reduction of interest rates • Despite that:

– In most cases (about 3/4) governments combine expenditure and revenue measures and …

– … unfortunately, in 2/3 of cases, the weight of revenue measures exceeds the weight of expenditure measures

This is no surprise: keep in mind the political content of fiscal policy

Fiscal consolidation and the economic and political cycles

• Empirical measurements have not confirmed a strong link between the economic cycle and the beginnings of consolidation periods, however, there is a link to the extent of reform ambition (in growth periods, reforms are more ambitious)

• There is a clear link (this is no surprise) with the political cycle (reforms would normally start right at the beginning of the legislative cycle)

• However, surprisingly, there is no robust empirical evidence of the textbook hypotheses of excess fiscal spending in pre-election periods …

Can you think of an exception?

Conclusions and lessons for us:

• The best moment for fiscal reforms in our country has been missed and came to an end in 2008-2009

• That does not imply that reforms are no longer feasible …

• On the contrary, if properly designed and implemented, they actually can contribute to the economic recovery (by providing more stability and inspiring more confidence) …

• ... Thus being more acceptable socially and politically

Fiscal rules and Fiscal watchdog - can they work or is just a kind of

smoke screen?

The concept of a constitutional limit to the public debt/GDP ratio and of a Fiscal council is part of the government manifesto – why and to serve what purpose?

The purpose as politically stated

• To face the deficit bias of fiscal policy• Maintain a sustainable and stable fiscal

environment, create a culture of stability which prevails on political circumstances

• Limit discretionary opportunistic interventions into the fiscal development

• Increase transparency• Increase accountability

↓• Support credibility

Variety of fiscal rules …

• Limits of deficit, debt or expenditure• Total or partial elements • Nominal or structurally/cyclically adjusted• Consolidated or selected levels only (central, regional,

funds etc) • Numerical, proportional ...• Adjusted for exogenous factors (or not)• Annual, mid-term, constant, running • Included in primary or secondary legislation, government

degrees, standards• Sanctioned or not

What criteria should they meet

• Clearly defined and easily interpreted• Easily understandable• Simple• Flexible• Adequate (to the purpose)• Consistent• Enforceable• Efficient

Sanctions

• Austria: financial penalties

• Belgium: limit the borrowing autonomy of the lower level of budgetary administration

• Switzerland: the excess expenditure must be duly financed by increased taxes

• EU: obligatory deposits, limit on use of EIB financing, freezing access to EU structural funds

What factors influence the choice of the rules …

• Political, administrative, geographical, how centralised the country is, organisation of the approval and control processes

• Structure (fragmentation) of the public finance conglomerate

• Quality of institutions• The budgetary situation (deficit and debt

levels) • External commitments

Functions ...

• Analytical (comparative) and signalling

• Disciplining and stabilising – limiting room for expansionary fiscal decisions

• Communication and accountability of fiscal authorities

Should this be applied in the Czech Republic and what purpose would it serve? Questions:

1. How credible actually the Czech fiscal policy is?

2. Are there any systemic risks threatening the credibility of the Czech fiscal policy

3. If the fiscal policy is credible, what use to have an additional tool?

4. What makes a rule really efficient?5. Do we have to invent something nes, specific,

or can we just copy from others?