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 …
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„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?
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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 budget
TOP 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 (%)
Greece
Romania
Ireland
Malta
UK
Latvia
Hungary
Spain
France
Poland
Estonia
Lithuania
Portugal
Italy
Slovakia
Slovenia
CR
Austria
Belgium
2008
EU27, 2008
SGP, 3%
Netherlands
Germany
Bulgaria
Cyprus
-14
Luxembourg
-10
-12
Denmark
Sweden
Finland
General Government Deficits
(in % of GDP, EDP methodology)
Czech R: -2.1% of GDP in 2008 and -6.6% of GDP in 2009
6
4
2
0
-2
-4
-6
-8
2009
EU27, 2009
Public debt in selected EU countries % of
GDP
And the bad news …
Public finance balance 2005-2011 bil CZK
The Czech public debt
2 000
45
Státní dluh (mld. Kč)
1 600
Dluh vládního sektoru (% HDP)
Státní dluh (% HDP)
40
35
800
25
20
15
400
10
5
0
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
20
14
mld. Kč
1 200
0
% HDP
30
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 effects
BUT: 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 …
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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.
2.
3.
Deficits and debts are increasing
Costs of servicing the debt are moving up
The intergenerational distribution of deficit/debt costs
becomes a pressing issue
4. The fiscal policy is no longer capable of playing an
anticyclical stabilisation role …
5. … implying increased costs of monetary policy
6. Negative impact on government credibility
7. Perception of the country and the fiscal policy by financial
markets
8. External context ...
9. ... Euro adoption
10. 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 …
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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
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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?