miguel buñuel leticia henar - angelfire · permanent e-mail: [email protected]. 2...

LESSONS FROM ENVIRONMENTAL

ECONOMICS FOR FISCAL DISCIPLINE IN THE EUROPEAN

UNION: CAN A SYSTEM OF TRADABLE DEFICIT PERMITS OR A TAX ON DEFICIT CREATION BE

A SUBSTITUTE FOR THE STABILITY AND GROWTH PACT?

Miguel Buñuel Leticia Henar

FUNDACIÓN BIODIVERSIDAD Departamento de Estudios, Publicaciones y Documentación Papeles de Trabajo sobre Medio Ambiente y Economía 1/2003 Working Papers on Environment and Economics 1/2003

Las series de Papeles de Trabajo de la Fundación Biodiversidad constituyen un vehículo para la diseminación de artículos científicos relacionados con el medio ambiente escritos por investigadores ligados a la Fundación, financiados por ésta, o realizados o presentados en el marco de actividades organizadas o patrocinadas por la Fundación Biodiversidad. Todos los originales publicados en estas series están sometidos a evaluación basada únicamente en sus méritos científicos. Como en toda serie de Papeles de Trabajo, los artículos así editados pueden ser posteriormente publicados por sus autores en revistas u otras publicaciones científicas.

La responsabilidad de las opiniones expresadas en las publicaciones

editadas por la Fundación Biodiversidad incumbe exclusivamente a sus autores y su publicación no significa que la Fundación se identifique con las mismas. Buñuel, Miguel, y Leticia Henar, 2003. “Lessons from Environmental Economics for Fiscal Discipline in the European Union: Can a System of Tradable Deficit Permits or a Tax on Deficit Creation Be a Substitute for the Stability and Growth Pact?”. Working Papers on Environment and Economics 1/2003. Fundación Biodiversidad, Madrid. © FUNDACIÓN BIODIVERSIDAD (for this edition) © Miguel BUÑUEL GONZÁLEZ and Leticia HENAR LOMEÑA Edita y distribuye: Fundación Biodiversidad Plaza de Alonso Martínez, 3 - 4ª planta E-28004 Madrid. ESPAÑA. Tel.: (+34) 91 121 09 20 - Fax: (+34) 91 121 09 39 http://www.fundacion-biodiversidad.es ISSN: 1578-8407 Depósito legal: M-9275-2003 Impreso en España usando papel ecológico Printed in Spain using ecological paper

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Lessons from Environmental Economics for Fiscal Discipline in the European Union: Can a System of Tradable Deficit Permits or a Tax on

Deficit Creation Be a Substitute for the Stability and Growth Pact?

MIGUEL BUÑUEL1 AND LETICIA HENAR2

FUNDACIÓN BIODIVERSIDAD AND UNIVERSIDAD AUTÓNOMA DE MADRID MADRID, SPAIN

Abstract

Environmental-economics maturity is highlighted by drawing very important lessons from it to be applied to such an apparently distant issue as it is fiscal discipline in the European Union. The reasons that usually justify the Pact for Stability and Growth are preventing inflationary debt bailouts, neutralizing inflationary pressures, offsetting politicians’ bias toward excessive deficits, and internalizing interest-rate spillovers. A rigorous economic analysis of these arguments shows that they do not suffice to support the Stability Pact. But whether the Pact is or is not justified, if the European Union decides that its objectives must be attained, it is convenient to study alternative mechanisms to achieve those objectives more efficiently. Among those mechanisms, a system of tradable deficit permits stands out as a very innovative proposal, equivalent to the tradable emission permits proposed by environmental economics. Although this system could be viable and improve the Stability Pact, both the possibility of the permit market being inefficient and applying Weitzman theorem suggest that a tax

1 Responsable de Estudios, Publicaciones y Documentación, Fundación Biodiversidad, Pza. Alonso Martínez, 3 – 4ª planta, 28004 Madrid, Spain. Tel: (+34) 91 121 09 20. Fax: (+34) 91 121 09 39. E-mail: [email protected]. Permanent e-mail: [email protected].

2 Departamento de Economía y Hacienda Pública, Facultad de Ciencias Económicas y Empresariales, Universidad Autónoma de Madrid, Campus de Cantoblanco, Carretera de Colmenar Viejo, Km. 15, 28049 Madrid, Spain. Tel: (+34) 91 207 37 49. Fax: (+34) 91 397 44 16. E-mail: [email protected].

MIGUEL BUÑUEL AND LETICIA HENAR ENVIRONMENTAL-ECONOMICS LESSONS FOR FISCAL DISCIPLINE IN THE EU

4

on deficit creation, inspired by environmental taxes, could be a more desirable substitute for the Stability and Growth Pact. JEL classification codes: E63, H62, H87, Q28. Key words: Pact for Stability and Growth, public deficit, deficit tradable permits, tax on deficit creation, fiscal discipline.

WORKING PAPERS ON ENVIRONMENT AND ECONOMICS 1/2003 FUNDACIÓN BIODIVERSIDAD

5

1. Introduction

The maturity of an economics branch can be linked to the degree to which other branches use the theoretical and empirical tools developed and conclusions derived by the former. After several decades of intense and fruitful development, and many policy-relevant contributions, environmental economics, which has relied on branches such as welfare economics and industrial organization, is a solidly established branch of economics. Environmental-economics maturity is further highlighted in this paper by drawing very important lessons from it to be applied to fiscal discipline in the European Union.

The European Union Treaty (EUT) imposes on Member States, in

the third stage of the Economic and Monetary Union (EMU), an obligation to avoid excessive deficits. It is considered that healthy public finances are crucial to preserve economic stability in the Member States and in the EU as a whole. Avoiding excessive deficits also alleviates pressures on monetary policy, and it fosters expectations of low and stable inflation, and hence of low interest rates. From this perspective, healthy public finances are an essential condition to achieve sustainable and no-inflationary growth, as well as a high level of employment. Because of these reasons, the Pact for Stability and Growth was established in 1997.

The Stability Pact fixes the rules to maintain budget discipline, and it

is based on four main pillars:

a) Stronger surveillance of medium-term fiscal positions: each Member State in the euro zone must balance its budget or have surplus in the medium run. This would allow automatic stabilizers to work when needed along the business cycle without exceeding the 3% reference value for the deficit-to-GDP ratio. Moreover, these Member States must present Stability Programs, which are plans for several years, updated every year, specifying medium-term fiscal objectives, and what


6

measures are going to be taken to adjust public deficit or surplus and to reach the desired level of public debt.

b) System of early warning: the Commission and the Council study

Stability Programs and supervise Member States’ budgets in order to warn early of any fiscal position that may lead to excessive deficit. When such a position is detected, the Council issues a recommendation to the affected Member State.

c) Excessive-Deficit Procedure: a deficit-to-GDP ratio above the reference

value of 3% is considered exceptional when it is a consequence of an infrequent event that escapes from the affected Member State’s control, and it provokes a large impact on the finances of its public administrations, or when it is a consequence of a severe economic recession (annual decline of at least 2% of real GDP). The Commission, the Economic and Financial Committee, and the Council participate in the procedure to determine if there exists an excessive deficit. But the final decision on the existence of excessive deficits rests on the Council (especially in those controversial cases in which real-GDP annual fall is not above 2%), as well as the decision on issuing a recommendation. The recommendation establishes appropriate measures to correct excessive deficit, and deadlines to adopt them. The affected Member State will be sanctioned if it does not adopt the recommended measures after ten months since the notification of excessive deficit. On the contrary, if that Member State adopts suitable actions, the procedure is put on hold under European authorities’ supervision, but the procedure would continue if those actions are finally not implemented or not suitable, or if excessive deficit is not corrected in the time limit established by the recommendation.

d) Structure and magnitude of sanctions: the sanction for not complying

with the Stability Pact consists of a deposit paid to the Commission, without earning any interest, which becomes a fine if public deficit is still excessive after two years. Interest earned by deposits and fines is distributed among participating Member States with no excessive deficit


7

in proportion to their share of their aggregate GNP. The deposit or fine is calculated as follows:

��

�

��

�

�

��

�

��

�

��

��

�

�� GDP1000

5,10

GDP100

3DeficitGDP

10002minSanction .

The next section of this paper analyzes if the reasons that usually

justify the Stability Pact (preventing inflationary debt bailouts, neutralizing inflationary pressures, offsetting politicians’ bias toward excessive deficits, and internalizing interest-rate spillovers) suffice to support instituting the Pact. But whether the Pact is or is not justified, if the European Union decides that its objectives must be attained, it is convenient to study alternative mechanisms to achieve those objectives more efficiently. Surprisingly, environmental economics, a field apparently very distant from the issue of fiscal discipline, provides very important insights for finding those alternative mechanism, which are studied in section 3. Among those mechanisms, a system of tradable deficit permits (Casella, 1999) stands out as a very innovative proposal, which is also studied in section 3 together with another instrument that we propose in this paper: a tax on deficit creation. Finally, conclusions are drawn in section 4 on what instrument may be more advantageous.

2. Weakness of the arguments that justify the Pact for Stability and Growth

2.1. Preventing inflationary debt bailouts

One of the main arguments that justify the Stability Pact is preventing the economic and financial crisis that unsustainability of a Member State’s public debt could generate, and hence preventing inflationary pressures on the European Central Bank (ECB). Suppose that


8

the government of a Member State, for any reason, finds difficult to repay its debt. If markets perceive that this Member State’s debt is becoming unsustainable, and that its government will need to take extraordinary measures (high tax increases, sharp expenditure cuts, debt- value reductions), the value of its bonds will decrease and the risk premium of issuing new bonds will become higher. This situation may provoke an economic and financial crisis that, starting from households as holders of bonds, quickly affects the bank system and the money market. Then, three options exist:

a) The ECB, forgetting its main objective and under pressure from the

country in crisis, may avoid the financial collapse of this Member State by monetizing its debt. This would make the ECB to loose its credibility, and increase inflation.

b) The rest of Member States may rescue the troubled country, assuming

the latter’s responsibility,3 which would affect negatively rescuers’ public accounts.

c) If none of the previous options is viable, the affected country should

leave the EMU, adopting again its national currency, and monetizing its debt.

In principle, it does not seem likely that the ECB may give up to any

country’s pressure, since the EUT establishes clearly its independence, as well as its objective: stability of prices (article 105). Moreover, article 21 of the European System of National Central Banks (ESNCB) Protocol establishes that the ECB cannot acquire public debt directly from its issuing, which makes harder to monetize debt. Nevertheless, this Protocol allows that the ESNCB supports the general policies of the EU mentioned in article 2 of the EUT, and among them we can find solidarity and cohesion policies

3 This option is limited by article 103 of the EUT, which introduces the so-called

“no bailout” clause, which establishes that no Member State or EU institution is responsible for the compromises acquired by other States.


9

toward real convergence. Therefore, any country could appeal to this solidarity when confronting a debt crisis. This is the reason that justifies the need for mechanisms that assure fiscal discipline among euro-zone countries, aiming to preserve stability of the system and credibility of the ECB.

The strength of the previous argument is questioned by several

authors, like Eichengreen (1997), who states that limits to debt creation are not a necessary condition for proper working of the single currency, as many examples indicate (the Monetary Union of Belgium and Luxembourg, or the Unions of West and Central Africa). Similarly, Eichengreen (1997) also notes that most Federations do not have rules limiting the federated states’ debt. Therefore, available evidence indicates that the argument that insists in the need for fiscal restrictions to protect the common currency from Member States’ abuse is not very solid. Moreover, according to the relationship established by Von Hagen and Eichengreen (1996) between fiscal structure of a State and likelihood of running into a financial crisis, regional governments mostly financed through transfers from their central governments (that is, those without fiscal co-responsibility) are the most likely to run into a debt crisis, demanding help from the central government, since they do not have their own taxes to finance their debt. Hence, since Member States are fiscally co-responsible in full, the bailout scenario is very unlikely in the EMU.

2.2. Neutralizing inflationary pressures more generally

Another argument used to justify the Stability Pact is offsetting inflationary pressures caused by public deficit also when Member States’ public finances are far from a debt crisis. This argument was crucial for the institution of the Pact, and it can be best illustrated by recalling Germany’s fear of countries with long records of high inflation and deficit (like Italy and Spain) entering the EMU, and that these countries could cause price


10

increases in the whole EMU by pressuring the ECB into financing their deficits through monetization.

The ECB looks for an equilibrium between the cost of inflation as a

tax and the cost of proper taxes, taking into account that the latter is paid by the citizens of the States running into deficits, while the former is a burden for all residents of the euro zone. The question is to what extent the ECB may resist the pressures that worried Germany so much, but we have already pointed out that both its independence and its basic responsibility for controlling inflation seem to guarantee that the ECB would resist those pressures. Therefore, the Stability Pact does not seem justified, since “in an ideal world in which the European Central Bank (ECB) would be totally committed to price stability, these constraints would be unnecessary indeed” (Beetsma and Bovenberg, 1999, 300).

2.3. Offsetting politicians’ bias toward excessive deficits Politicians’ bias toward increasing public deficit is very much related

to the theory of “fiscal illusion,” according to which voters overestimate benefits from public expenditure and underestimate costs from future taxation to finance that expenditure. As a result of this illusion, fiscal policies become asymmetric with respect to business cycles, that is, deficit increases during recessions, but it does not become surplus during booms. In addition, fiscal balance also depends on electoral cycles (governments increase their expenditures when they are close to elections), on the composition of governments (coalitions make more difficult fiscal adjustments), and on how fiscal process is designed (Alesina and Perotti, 1995; Barea, 1997).

Although that bias exists, offsetting it does not seem a strong

argument to justify the Stability Pact, because this eliminates the symptoms but not the underlying problem. The Pact only establishes numerical objectives, and hence it only encourages politicians to “make up” their


11

public accounts (for instance, “creative accounting” maneuvers taken by several countries to access the third stage of the EMU). As Eichengreen and Wyplosz suggest, “imposing numerical caps on budget deficits only encourages devious behavior to meet the letter but not the spirit of the law” (1998, 78).

2.4. Internalizing international interest-rate spillovers

An expansive fiscal policy by a Member State may affect other EMU countries positively, through increased imports by the former, and negatively, through its possible effect on interest rates of the euro zone and on the euro exchange rate. The problem is that negative effects may offset the initial positive impulse on other countries’ exports, causing a contraction of their aggregate demand. This concern was already expressed by the Delors Report, which indicated that the EMU could lead to less disciplined fiscal policies because a system of fixed exchange rates makes possible to finance an increase of public deficit in foreign markets without extra expenditures associated to paying a devaluation-risk premium, which no longer exists.

Therefore, it is important to determine what is the net effect of

positive and negative consequences of any Member State’s fiscal policy on the rest of EMU countries’ output. Several studies show, both theoretically and econometrically, that both kinds of effects tend to cancel out, and hence spillovers are quite small in the European case (European Commission, 1990; Masson and Tailor, 1993). Moreover, since Member States borrow money in world capital markets, not in a single market for Europe, it is unlikely that a country’s debt may produce large effects on interest rates. Besides, an increase of a country’s risk premium due to its growing debt does not imply that the other EMU countries’ risk premium increases too; financial markets can discriminate among debtors, not being equal all bonds issued in euros.


12

We should also note that interest-rate spillovers do not need to be more pronounced in the EMU that they were before, since European economies were already interdependent before the EMU was instituted. Moreover, the Exchange Rates Mechanism of the European Monetary System implied that the rest of countries were dependent on fiscal decisions by the monetary leader, Germany. In conclusion, interest-rate spillovers seem scarcely relevant in the EMU.

2.5. Conclusions

Since the arguments that usually justify the Stability Pact do not seem very strong, we may ask what is the purpose of the restrictions imposed by the Treaty of Maastricht and the Pact itself. The European Commission (1990) argued in favor of fiscal discipline as a priority by pointing out that many States confronted levels of public debt whose sustainability was very doubtful, an argument supported by the European Monetary Institute (ECB predecessor) in its first report. These European authorities based their fears in the possibility of lower incentives toward fiscal discipline in the EMU because of the following reasons:

a) The Mundell-Fleming effect may act as an incentive to increase public

debt permanently, or at least for a long time. b) Even if negative external effects are small, two or more national

governments having expansive fiscal policies simultaneously may increase money demand in the EMU, forcing the ECB to raise interest rates.

c) In the EMU, governments are not pressured by exchange-rate risks,

which used to be an incentive to controlling fiscal expansions. d) Controlling inflation may be perceived as the ECB’s role and

responsibility; hence national governments have less arguments to resist pressures for increasing their expenditures.


13

e) Greater integration and the Single Market may lead to lower tax revenues, which could lead to larger deficits.

In the opinion of these European institutions, all of the circumstances

mentioned above may create incentives for national governments to increase their deficits, and if debt accumulation lasts in time it may provoke a bailout scenario. This is the reason that would justify the institution of fiscal restrictions. In any case, whether the Stability Pact is or is not necessary, what we should ask is if its same objectives may be reached more efficiently through the use of other mechanisms. The rest of this paper is devoted to answering this question.

3. Lessons from environmental economics for fiscal discipline in the Economic and Monetary Union

3.1. Introduction Drawing lessons from an apparently distant field, as it is

environmental economics, Casella (1999) proposes an innovative approach to attain the objectives of fiscal discipline in the EMU: a system of tradable deficit permits. The starting point of this proposal is recognizing the parallels between pollution and deficit. In both cases, we face a problem of negative externalities, which a welfare-maximizing government could solve if it had complete and perfect information. In the case of deficit, the centralized solution needs that fiscal policy, like monetary policy, be in the hands of a single European institution, something that does not seem possible nowadays.

In the case of environmental policy, the traditional answer to

pollution consisted of quantitative restrictions imposed through a command-and-control approach. This is precisely what the Stability Pact does with regard to deficit in the case of fiscal discipline in the EMU. However,


14

environmental economics shows that a policy that imposes the same behavior to all emission sources is very inefficient when the costs of pollution abatement vary significantly across sources. Efficiency requires that sources reduce their emissions until their marginal abatement costs are equalized. This is the necessary condition for minimizing the total cost of pollution abatement, and it may be attained by using taxes on pollution emission or tradable emission permits. In the case of fiscal discipline, and mimicking Pigouvian taxes, the externality caused by deficit could be internalized by imposing on all countries a tax per unit of new deficit whose rate were equal to the marginal social cost caused by that deficit to the whole EMU. Obviously, the necessary information to calculate that tax is very difficult to obtain. The alternative option recommended by Casella (1999) consists of establishing a system of tradable deficit permits, inspired by the very important experience offered by the system of tradable permits for sulfur-dioxide emissions in the USA. While the Stability Pact imposes the same quantity of deficit to all Member States, ignoring that complying with it produces very different costs for each country (depending on its business-cycle stage, its economic structure, and the volume of its outstanding debt), a system of tradable deficit permits would allow that deficits were larger where their value is greater, hence minimizing the costs of attaining the global deficit objective for the EMU.

Figure 1 illustrates how total costs are minimized by a tax on deficit

creation and by a system of tradable deficit permits in the case of fiscal-discipline policy. Suppose a EMU composed of two countries with the same GDP (A and B), and both with a deficit level of 6% of GDP. Assume also that their marginal costs of abating deficit (MAC) are increasing (hence the slope of MAC is negative, indicating that each unit of deficit costs more to be reduced than the previous one), and that A’s marginal abatement costs are greater than B’s (the slope of MACA is steeper than the slope of MACB). If the objective of this EMU is that global deficit is reduced to 3% of global GDP, a piece of regulation like the Stability Pact may impose on each country the obligation of reducing deficit to 3% of its GDP. In this case, total cost of abating deficit would be the sum of areas DFC and DEC,


15

Figure 1: Illustration of total-cost minimization by a tax on deficit creation

and by a system of tradable deficit permits

Source: based on Buñuel (2002a, 87).

that is, the cost for A and B of going from a 6 to a 3% deficit-to-GDP ratio. If instead of imposing such an obligation, the EMU creates a tax on deficit whose rate equals t, the same objective for global deficit would be attained, but the distribution of the required reduction would be unequal across countries, and total abatement cost would be minimized. The tax would lead each country to reduce its level of deficit while the cost of abating a new unit is lower than t, which is what the country has to pay for each non-abated unit. Hence, both countries would reduce their deficits until MACA=t=MACB. As a consequence, A and B would reduce their deficits,

4% 2% Deficit

MAC

6%

t

3%

MAC A

MAC B

A

B

C D

E

F

G

H I

J


16

respectively, to 4 and 2% of their GDP, with abatement costs equal, respectively, to areas GHC and ABC. The result would be a level of total deficit again equal to 3% of global GDP, but total abatement costs would be GHC+ABC=DFC+DEC-IFHJ. That is, the same result would be attained with savings in total abatement costs equal to the stripped area IFHJ.4

Figure 1 also explains that the result just described would be the

same if we use a system of tradable deficit permits. In this case, the EMU could assign to each country deficit permits that allow a deficit-to-GDP ratio of 3%, the global target. Since A’s marginal abatement cost at the 3% level is DF and B’s is DE < DF, there exists an opportunity for both countries to improve their situation by trading permits at a price p such that DE<p<DF. This trade opportunity will exist precisely until A and B are, respectively, at deficit levels of 4 and 2% of their GDP. Hence, when the price of permits is p=MACA=MACB, both countries exchange the number of permits required to attain the efficient result. The price must be exactly that, since permit demand would exceed supply if it were lower, and permit supply would exceed demand if it were greater.

3.2. Casella’s (1999) proposal of a system of tradable deficit permits

A system of tradable deficit permits would entail fixing a global deficit cap for the whole EMU, and let the market distribute this total deficit among Member States. Each country would receive a certain number of tradable permits annually, which would amount to X% of its GDP, being X the cap for the deficit-to-GDP ratio fixed for the whole EMU. When a country’s deficit statistics were made public in the following year, this country should have in its permit account at least an amount equal to its deficit, which would be withdrawn from that account. If the country would

4 For each country individually considered, the cost of paying the tax adds to the

cost of abating its deficit, but since tax payments are revenue for the EMU, and hence for every country, each country’s net financial situation is better paying the tax than with a piece of regulation à la Stability Pact. In particular, savings for A are equal to area FHI, and B’s savings are equal to area BIE. Of course, FHI+BIE=IFHJ.


17

not have enough permits, it would face a financial sanction, which should be high enough to be a sufficient non-compliance disincentive, and the missing permits would be subtracted from next year allotment.

With this system, if a country wants to incur in a deficit larger than

X% of its GDP, it will need to buy more permits. On the contrary, if a country has a lower deficit, it could sell its remaining permits or save them to be used in following years. This last possibility allows for certain degree of inter-temporal deficit planning, but only in the sense of incurring today in less deficit to increasing it in the future, not being advisable to let countries use in the present deficit permits from future years, to avoid temptations from short-horizon governments.

With the Stability Pact, countries must pay a cost when their deficit

exceeds X% if the sanctions foreseen by the Pact are imposed on them. With the permit system, the cost of exceeding that percentage is the cost of buying the permits. The difference between both systems is that while the cost of permits is determined by the market, sanctions are arbitrarily fixed by the Stability Pact. The cost of permits implies that a share of the new deficit in excess of X% must be devoted to paying for the permits. Therefore, if the price of permits is p, each government can devote only 1�p euros to finance new public expenditure for each euro of new deficit in excess of X%, or, what is the same, one euro of new public expenditure requires buying 1�(1�p) euros of permits.

The system described implies that the end distribution of permits

among Member States is irrelevant while the aggregate objective of deficit for the EMU is attained. However, if we are concerned with a debt crisis in the EMU whose origin is that countries already excessively indebted are unable to reduce their deficits, then the end distribution of permits is very relevant. Again, environmental economics offers a solution to this problem: when emissions are heterogeneous by source in the sense that they produce different levels of pollution where the externality is suffered, the system of emission permits must be changed into a pollution-permit system. In the


18

latter, the permits of sources that generate different effects on pollution cannot be traded in a 1-to-1 relation; for instance, if the effect of a source on pollution is double than the effect of another source, their permits will trade in a 1-to-2 relation. In our case, the objective is controlling the effect of deficit on EMU stability; hence permits should trade in relation to the impact that national deficits have on some index of the financial fragility of the EMU. Casella (1999, 335) suggests that the average squared deviation of the debt-to-GDP ratio of each country from a reference level could be such an index. Hence, the permits that each country should have at the end of each year would not equal their deficit, but they would be proportional to their deficit using the debt-to-GDP ratio as a proportionality factor.

A system like the one described above could be too complicated, but

again environmental economics offers a simpler solution: a system of zonal permits, which can only trade between sources that belong to the same zone (in which the effect of emissions on pollution is mostly homogeneous). Analogously, the countries of the EMU could be divided in groups (probably, it would not be advisable that they were more than two) according to their debt-to-GDP ratios. Therefore, permit trading would occur only between countries belonging to the same group. Since the effect of a country’s debt on the financial fragility of the EMU depends on more factors than the debt-to-GDP ratio, Lockwood (1999, 348) suggests that the zonal classification be done using the sovereign credit ratings of Moodys or Standard and Poor’s as an aggregate indicator of the likelihood of a country’s debt default.

Following Casella (1999), it is easy to demonstrate that the market

solution for permit distribution is unique and efficient. Let’s denote country i’s deficit as di, the cap on allowed deficit as D (therefore, �i di �D), the cost for country i of choosing di given D as Ci(di,D), the deficit that i would choose if it would not exist a cap on total deficit as �i, and assume that Ci�>0, Ci�>0, and Ci�(�i,D)=0. The central planner’s problem is the following:


19

� ��

ii

iiid

DdDdCi

subject to ),(min ,

whose solutions are

��

� ),( * DdC ii ,

� �

ii Dd * , and

0* ��

��

��

ii Dd� ,

where � is the Lagrange multiplier (the shadow price of an extra unit of deficit), and di

* is the solution to the central planner’s problem. With the institution of a permit system, each country would receive a number of permits that would allow it to have a deficit d0i, so that �i d0i = D. Given that for each euro of new deficit in excess of d0i only 1�p euros can be devoted to finance new public expenditure, which we denote as gi, it is clear that gi� di – p(di – d0i). Hence, the problem for each country is the following:

)( subject to )(),(min 00 iiiiiiiid

ddpgdddpDgCi

�� ,

whose solutions are

ppDgC ii�

��

�1

),( * , and

ppdg

d iii

�

�

�

10

*** ,


20

where di** is the solution to each country’s problem, gi

* = di

** – p(di**

– d0i), and p solves the market-equilibrium conditions. Since p is equal for every country, solution (2) implies that the marginal cost of deficit abatement is equalized across all Member States. Solutions (2) and (1) are equal if and only if � = p�(1�p). This equality always holds, as Casella (1999, 356) demonstrates.

3.3. Advantages of a system of tradable deficit permits with respect to the Stability Pact

The main advantages of the system proposed by Casella (1999, 329-

330) with respect to the Stability Pact are the following:

a) It provides each country with flexibility for planning its fiscal policy, and adapting to the asymmetric shocks that it may experience, while maintaining the global objective of deficit for the EMU.

b) A country’s fiscal discipline is rewarded by the possibility of selling its

unused permits, while the Stability Pact has been criticized because it only penalizes not complying during economic depressions, but it does not reward good fiscal behavior during booms (Bean, 1998). Therefore, a permit system creates incentives for countries to come closer to the objective of zero deficit or surplus.

c) The flexibility mentioned above makes possible that a country acts

before suffering a great recession, while the Stability Pact only exonerates excess deficit when recession has occurred, and therefore when stabilization policy has failed.

d) A system of tradable deficit permits is much more transparent than the

Stability Pact, since the latter admits political exceptions, while the former is based on clear rules. As a consequence, this system is much easier to be understood by citizens, to predict its results, and, more important, to be enforced.


21

e) The main advantage of the tradable-permit system with respect to the Stability Pact is that, for an equal enforcement effort, the permit system is always less costly than the Pact, since the possibility of trading permits reduces the cost for each country of complying with the quantitative restriction imposed by the system.

3.4. Criticism to the system of tradable deficit permits

The main criticism to the system proposed by Casella (1999) is that it is very unlikely that the market for permits be efficient, and without efficiency there will not exist the main advantage of the system, that is, minimization of costs. As Pagano (Casella, 1999, 352) suggested, two factors will probably make the permit market less efficient and liquid than it is desired. The first factor is imperfect competition, which will probably characterize the market, since its trades will hardly be anonymous, and hence collusion between buyers and sellers is likely to arise. The second factor is the problem of adverse selection that may be caused by the privileged information on future trades and prices that large buyers or sellers will probably have.

The problem of imperfect competition is worsened by the reduced

number of participants in the market, although Casella (1999) argues that the system of double auction should be used in the market for permits, and this system has sufficiently proven its ability to replicate the results of a perfect-competition market even when the number of sellers and buyers is small. Moreover, Casella suggests that regional governments of Member States and “market makers” should participate in the system, and they could increase competition and liquidity.

3.5. An alternative proposal: a tax on deficit creation

Casella rejects the tax option because “the information required to calculate the tax correctly is very difficult to obtain: a tax scheme imposes a


22

daunting task on the regulator, with the likely result that the realized deficits could be seriously different from the desired objectives” (1999, 325). Certainly, a deficit tax equivalent to an optimal Pigouvian tax would require from EMU authorities to have an information out of their reach: they should know the benefits and costs that the deficits of all Member States impose on the EMU as a whole, and then choose the tax rate that maximizes aggregate net benefit. But Casella does not mention that fixing a global-debt cap for the EMU implies solving the same problem, and therefore it imposes the same information requirement if we want to maximize aggregate welfare in the EMU. The same situation occurs in the environmental arena: the information required to calculate the optimal level of pollution is not usually possessed by the regulator, and hence she can hardly establish optimal taxes or tradable-permit systems. That is why, in practice, the regulator can only set “reasonable” emission standards, not knowing what the optimal levels of emissions are. However, also in this second-best framework, taxes and tradable permits are desirable instruments, because they make possible to reach the standards efficiently, that is, at minimum cost, since they equalize the marginal cost of emission abatement across emission sources.

The tax proposed here and Casella’s tradable-permit system are

equivalent instruments, which may be shown using the same model described at the end of section 3.2. Consider now the introduction of a tax on the deficit that each country creates, whose rate (by unit of deficit) is denoted as �. Therefore, gi� di (1 – �). Now, the problem for each country is the following:

�

�

�

��

1 subject to ),(min i

iiiid

gddDgC

i

,

whose solutions are

�

�

��

��

1),( ** DgC ii , and


23

��

�

1

***** i

ig

d ,

where di

*** is the solution to each country’s problem, and gi**

= di*** (1 – �).

Solution (4) indicates that marginal cost of reducing deficit is again equalized across countries, and therefore the use of a tax on deficit creation also minimizes the aggregate cost of fiscal-policy discipline. Note that it can be deduced from (5) and (3) that, if the result is exactly the same with a permit system than with a tax, that is, if � = p, the same level of new public expenditure in both cases (gi

** = gi

*) would require creating more deficit when a tax is used than when we use a permit system, since di

*** > di** in such case. The reason for this is that, although the unit

cost of deficit is the same, this cost is paid for each unit of created deficit with a tax, while with permits countries only need to pay that unit cost for the deficit in excess of the level initially allowed by the permits received, and they can even obtain revenues by selling permits when they create less deficit than allowed. Nevertheless, this does not mean that a system of permits is a superior instrument in relation to a tax, since there exist mechanisms that make possible that taxes are as, or even more, advantageous than permits with regard to the cost that its payment imposes on countries. Again, we may derive conclusions from environmental economics (Buñuel, 2002b): revenues from environmental taxes and charges may be earmarked to environmental expenditure, may increase total public revenues, may be returned to tax payers through lump-sum transfers, or may be used to reduce other taxes (ecological fiscal reform). In our case, the parallel to an ecological fiscal reform would be that revenues from the tax on deficit creation became one more of the EU resources, and they were used to reduce the contributions of Member States. Since in this case there does not exist the main argument in favor of an ecological fiscal reform, that is, that a double dividend5 may exist, it seems advisable that revenues are

5 The first dividend is the improvement of the environment, and the second is the

improvement of the fiscal system if revenues are used to reduce distorting taxes (and hence to reduce their excess burden).


24

returned to Member States through a lump-sum transfer in proportion to their share of aggregate GDP. Accordingly, countries with deficits that are larger than the EMU average deficit would make a net payment that would benefit countries with deficits that are below that average. Therefore, the incentives that exist with a permit system to reduce deficit more than the EMU target are also present with a tax, and fiscal discipline is still rewarded. Moreover, a level of deficit exempt from tax payment could be established, which could replicate the effect of receiving the initial allotment of permits free of charge.

3.6. Initial comparison between a system of tradable permits and a tax From (2) and (4), it is concluded that the solutions with a system of

permits and with a tax are equal only if the EMU authority chooses a tax rate equal to the price of permits in perfect competition. Since that authority does not know Member States’ marginal costs of reducing deficit, it will be very difficult that it establishes the correct tax rate to reach exactly the deficit objective that it may want to set. To avoid this problem, the EMU authority should follow a trial-and-error process, modifying the tax rate according to the results obtained until the desired objective is reached. The practical problems of this procedure are obvious and make it scarcely viable. However, this does not mean that a system of tradable permits is a superior instrument. For this system to minimize the cost of attaining the deficit objective, it is required that the market for permits works in perfect competition, and the participating agents act to minimize costs, but we have already pointed out in section 3.4 that at least the first condition will be hard to satisfy in practice. Moreover, since the EMU authority does not know marginal costs of deficit abatement, it will not know either the costs that it imposes on Member States when setting a cap on deficit. Hence, even if the market for permits works efficiently, and those costs are minimized, the choice of the cap on aggregate deficit may be very far from maximizing aggregate welfare for the EMU. Therefore, we need to establish criteria that help us to choose between taxes and tradable permits, given the uncertainty faced by the EMU authority, and again environmental economics gives us


25

the answer. In the following section, we will apply to the case of fiscal discipline the criterion for choosing between taxes on pollution emissions and tradable emission permits when there exists uncertainty.

3.7. The choice between tradable permits and taxes according to Weitzman theorem

A Pigouvian tax and a system of tradable emission permits are

equivalent instruments when there does not exist any problem of information or uncertainty.6 However, in practice, the government is poorly informed on the damages caused by pollution (that is, the benefits of reducing pollution), and, especially, on firms’ costs of emission abatement. Moreover, both the costs and even more the benefits of reducing emissions are frequently subject to great uncertainty. Weitzman (1974) was the first who established the criterion for choosing between price instruments (taxes) and quantity instruments (emission permits) when there exists uncertainty, giving birth to the so-called Weitzman theorem, which has been broadly applied to the particular case of controlling pollution.

Weitzman theorem holds when the functions of marginal pollution-abatement benefits and costs are linear, the function of marginal abatement benefits (MAB) is known with certainty, and the function of marginal abatement costs (MAC) has an error term (�) such that E(�)=0. Figure 2 illustrates this theorem. Let’s denote the total quantity of pollution currently emitted as X, and consider a Pigouvian tax with rate � per unit of emission, and a system of tradable emission permits that issues X�x permits, each of which allows one unit of emission, where x is the quantity of pollution abated. If the government anticipates correctly marginal abatement costs (that is, when � = 0), the optimal result (a level of abatement of xo units of pollution) will be attained whether we use a Pigouvian tax with rate �o or we use a system of tradable emission permits issuing X�xo permits. On the contrary, if the government thinks that marginal abatement costs are larger

6 See, for instance, Buñuel (2001, 33).


26

Figure 2: Illustration of Weitzman theorem

Source: based on Buñuel (1999, 97).

than they really are (��> 0), it will choose a rate that is too high (��>� o), and this rate will lead to an excessive level of pollution abatement (x�), or it will issue too many permits (X�x p>X�x o), which will result in an insufficient level of pollution abatement (xp). In the first case, the lost of social welfare is represented by area CDE, and by area ABC in the second case. Therefore, three cases are possible: a) Slope(MAB) = slope(MAC) � area CDE = area ABC � indifference

between a Pigouvian tax and a system of tradable emission permits.

MAB, MAC

Pollution abatementx x xop �

�

�

�

o

MAB

MAC

MAC + �

A

B

C

D

E


27

b) Slope(MAB) > slope(MAC) � area CDE > area ABC � a system of tradable emission permits is preferable.

c) Slope(MAB) < slope(MAC) � area CDE < area ABC � a Pigouvian tax

is preferable. Analogously, when the government underestimates marginal abatement costs (� < 0), conclusions are the same. If we apply Weitzman theorem to our case, we conclude the following. If the EMU authority wants to be sure that a certain objective of deficit reduction is attained, whatever its cost may be, it must choose a system of permits. On the contrary, if the objective is minimizing total costs, the conclusion of Weitzman theorem is that permits are preferable when costs are more sensitive to changes in financial fragility of the EMU than to changes in the national expenditure or taxes that make possible to reduce deficit. When the costs are more sensitive to changes in the latter than to the changes experienced by the level of aggregate deficit, a tax is preferable. Obviously, if aggregate deficit is so large that we are near a debt crisis, the marginal benefit of reducing deficit may be very high (the function of marginal abatement benefits would be very steep). In this case, we should prefer using a system of permits with a deficit cap that guarantees that we escape from a situation of financial fragility. However, what we studied in section 2 seems to indicate that a debt crisis is not a serious threat for the EMU, seeming more likely that the slope of the function of marginal abatement benefits is relatively smooth. On the contrary, the function of marginal abatement costs may be very steep, since, as countries reduce more their public expenditure or increase their taxes to reduce their deficit, they will have to reduce expenditure programs that are increasingly profitable (being forced to reduce their deficit, they will eliminate first the programs that are less profitable) or create larger disincentives by augmenting fiscal pressure. Therefore, Weitzman theorem suggests that the expected loss of welfare produced by the wrong choice of the tax rate or the cap on allowed deficit is lower in the case of a tax.


28

4. Conclusions A rigorous economic analysis shows that the arguments that usually

justify the Stability Pact (preventing inflationary debt bailouts, neutralizing inflationary pressures, offsetting politicians’ bias toward excessive deficits, and internalizing interest-rate spillovers) are quite weak. Nevertheless, both the Commission and the European Monetary Institute consider that fiscal discipline is a priority, given the possibility that the incentives to keep it are weaker in the EMU. This could lead governments to expand their deficits excessively, and, if they do so for a sufficiently long time, a bailout scenario could drag down all Member States. In any case, whether the Stability Pact is or is not necessary, this paper studies if its same objectives may be attained more efficiently through other mechanisms.

Surprisingly, environmental economics offers very important lessons

to find those alternative mechanisms. The parallels between controlling pollution and controlling deficit in the EMU are due to the fact that in both cases we face a problem of negative externalities. In particular, Casella (1999), inspired by the system of tradable permits for emitting sulfur dioxide in the USA, proposes a system of tradable deficit permits. This system could imply a significant improvement with regard to the Stability Pact, since, preserving the global objective of deficit for the EMU, it provides flexibility for each country to plan its fiscal policy and to adapt to asymmetric shocks. Most of all, a tradable deficit-permit system would be less costly than the Stability Pact, because the possibility of buying and selling permits would reduce the cost for each country of complying with the quantitative restriction imposed by the aggregate cap on deficit. However, it is likely that the market for permits be inefficient, which could offset the advantages of the system. This suggests the need to explore other instruments, among which this paper proposes a tax on deficit creation, whose revenues would be returned through lump-sum transfers to Member States in proportion to their share of aggregate GDP, and with the possibility of establishing a deficit level exempt from taxation.


29

Both using a system of tradable permits and using a tax are subject to the common problem of the EMU authority lacking complete and perfect information, which makes this authority unable to choose adequately both the maximum number of permits and the tax rate. We may apply Weitzman theorem to determine which mechanism is more advantageous. From applying this theorem, we conclude that, if we are close to a debt-crisis “threshold,” we should use a system of permits that imposes a maximum level of deficit such that the threshold is never crossed. However, evidence seems to indicate that we are far from such a threshold. On the contrary, as a country’s deficit is reduced further (and, hence, as its public expenditure is decreased or its taxes raised), it is normal to expect that the cost of deficit abatement may increase more than proportionally. Hence, Weitzman theorem suggests that a tax on deficit creation that imposes a “reasonable” cost (even if the EMU authority does not know what deficit reduction will produce) may be more desirable than a system of permits that offers security on attaining a certain objective for maximum deficit, but maybe at an excessive cost (which is not known either by the EMU authority ex ante).

References Alesina, Alberto, and Roberto Perotti (1995): “The political economy of

Budget Deficits,” IMF staff papers 42, pp. 1-31. Barea Tejeiro, José (1997): Disciplina presupuestaria e integración de

España en la Unión Monetaria. Discurso de recepción en la Real Academia de las Ciencias Morales y Políticas. Madrid.

Bean, Charles (1998): Discussion of Barry Eichengreen and Charles

Wyplosz, “The Stability Pact: more than a minor nuisance?,” Economic Policy 26, pp. 104-107.


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Beestma, Roel M. W. J., and A. Lans Bovenberg (1999): “Does Monetary Unification Lead to Excessive Debt Accumulation?,” Journal of Public Economics 74, pp. 299-325.

Buñuel, Miguel (2002a): “Teoría de la imposición ambiental.” In Alberto

Gago and Xavier Labandeira (editors), Energía, fiscalidad y medio ambiente en España. Estudios de Hacienda Pública. Madrid, Instituto de Estudios Fiscales, pp. 85-100.

Buñuel, Miguel (2002b): “El uso de instrumentos fiscales en la política del

medio ambiente: teoría, práctica y propuesta preliminar para España”, Working Papers on Environment and Economics 1/2002. Madrid, Fundación Biodiversidad.

Buñuel, Miguel (2001): “The Effect of Emission Permits and Pigouvian

Taxes on Market Structure,” Working Papers on Environment and Economics 1/2001. Madrid, Fundación Biodiversidad.

Buñuel, Miguel (1999): El uso de instrumentos económicos en la política

del medio ambiente. Colección Estudios 75. Madrid, Consejo Económico y Social.

Casella, Alessandra (1999): “Tradable deficit permits: efficient

implementation of the Stability Pact in the European Monetary Union,” Economic Policy 29, October, pp. 323-365.

Eichengreen, Barry (1997): European Monetary Integration: Theory,

Practice and Analysis. Cambridge and London, MIT Press. Eichengreen, Barry, and Charles Wyplosz (1998): “The Stability Pact: more

than a minor nuisance?,” Economy Policy 26, pp. 65-120. European Commission (1990): “One Market, One Money”. European

Economy 44.


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Lockwood, Ben (1999): Discussion of Alessandra Casella, “Tradable deficit permits: efficient implementation of the Stability Pact in the European Monetary Union,” Economic Policy 29, October, pp. 347-349.

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Currency Areas,” Journal of Common Market Studies 31, pp. 29-44. Von Hagen, Jürgen, and Barry Eichengreen (1996): “Federalism, Fiscal

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Studies 41, October, pp. 477-491.

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PAPELES DE TRABAJO DE LA FUNDACIÓN BIODIVERSIDAD FUNDACIÓN BIODIVERSIDAD WORKING PAPERS

Papeles de Trabajo sobre Medio Ambiente y Economía Working Papers on Environment and Economics 2001: 1. MIGUEL BUÑUEL, “The Effect of Emission Permits and Pigouvian Taxes

on Market Structure,” pp. 47. 2. MIGUEL BUÑUEL, “Estimating the Effects of Technology and Depletion

on the Real Price of Copper in the U.S. Using a Cointegration Approach,” pp. 62.

2002: 1. MIGUEL BUÑUEL, “El uso de instrumentos fiscales en la política del

medio ambiente: teoría, práctica y propuesta preliminar para España”, pp. 47.

2. RAFAEL MÁRQUEZ, “La fiscalidad de la energía en la Unión Europea: el estado de la cuestión”, pp. 30.

3. MIGUEL BUÑUEL and MARÍA LUISA DELGADO, “The Effect of Social Perception of Environmental Problems and Goods on the Practice of Cost-Benefit Analysis,” pp. 30.

2003: 1. MIGUEL BUÑUEL and LETICIA HENAR, “Lessons from Environmental

Economics for Fiscal Discipline in the European Union: Can a System of Tradable Deficit Permits or a Tax on Deficit Creation Be a Substitute for the Stability and Growth Pact?,” pp. 31.

2. RAFAEL MÁRQUEZ, “La fiscalidad de los montes en España”, pp. 46.

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