Fiscal planning in Europe: How to improve credibility?

Roel Beetsma, Massimo Giuliodori, Mark Walschot, Peter Wierts, 13 September 2010

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European finance ministers face an unenviable dilemma. How do they balance a desire not to slash budgets now – at a time when their economies are at their weakest – with the need to be seen as having a credible and sustainable long-term plan? Perhaps one reference point might be the European Commission, whose recent reform proposals have spurred on the debate over Europe’s fiscal crisis. In this column, we outline our recent research on budget credibility and why we believe that these reforms are, by and large, a positive move. Yet we fear that, without additional policies, these reforms could weaken accountability instead of strengthening it.

Investigating budget credibility

Surveillance of the EU fiscal rules is based on the national fiscal plans which are embedded in the Stability and Convergence Programmes. Yet, as Figure 1 shows, these national fiscal plans suffer from a lack of credibility. Figure 1 contrasts fiscal projections (red lines) with fiscal outcomes since the start of the Stability and Growth Pact (dark line).

In search for improvement, research has already made the case for independent growth forecasts and stronger domestic fiscal institutions (Jonung and Larch 2006 and Debrun et al. 2008). Yet, this research, as most of the literature on fiscal reaction functions, is based on ex post fiscal data. In two recent studies, we use real time data directly from the Stability and Convergence Programmes and the national budget as the most direct source on the behaviour of fiscal policymakers. In Beetsma et al. (2009) we use data for a panel of 14 EU countries but over a relatively short period (1999-2007), while in Beetsma et al. (2010) we focus on the Netherlands only, but over a much longer time period (1958-2009).

Figure 1. Fiscal plans and outcomes in the Eurozone

Size of planning bias

In our research on the SGP experience, we find that planned fiscal consolidation is on average back-loaded towards year 2 and 3 of the planning horizon, and that it is based more on planned expenditure cuts than on revenue increases. Implementation errors are large, however, and even slightly outweigh planned fiscal consolidation. The slippages are mostly concentrated on the expenditure side of the budget. However, they tend to be smaller for countries with tighter fiscal constraints at the national level. Moreover, our data show that larger planning errors coincide with higher budget deficits, and confirm that real growth projections are too optimistic on average.

When seen in this perspective, results for budget implementation in our case study on The Netherlands show a strikingly different picture. Whereas planned budgetary outcomes also suffered from an optimism bias until 1983, the opposite is the case for the period after 1983. This is mainly due to cautious revenue projections. Moreover, real growth projections underlying the budget are on average unbiased. These differences in findings may provide relevant insights into the driving factors of distorted planning under the EU fiscal rules.

Figure 2. Implementation error in the budget balance over output ratio

Note: The error is the deviation of the first-release outcome from the plan. The sample period is 1959-2009.

Sources of biased planning

Our regression analysis of the Stability and Growth Pact experience confirms that biased growth projections and institutional frameworks both play a role in explaining implementation errors. The Dutch experience provides more detailed information on how these elements have operated in this particular case.

First, already since 1962, the independent and official Dutch forecasting agency has provided the macroeconomic scenario on which the budget is based. This has insulated the Dutch budget from systematically over-optimistic macroeconomic assumptions as a source of fiscal bias.

Second, perhaps surprisingly, we find that the introduction of expenditure ceilings in 1994 coincides with an increase in revenues relative to plan. This effect is due to the simultaneous introduction of “trend based budgeting” that was based on deliberately cautious growth assumptions (until the early 2000s).

Overall, we find that the link between political fragmentation and expenditure pressure still holds in the Dutch case. However, it is counterbalanced by institutional reforms that constrain expenditures and thereby translate revenue windfalls into a better budget balance (instead of higher expenditures).

What does this mean for the current reform debate?

The European Commission has issued two Communications (EC 2010a and 2010b) with reform proposals for the EU fiscal framework. On the basis of this input, the so-called Van Rompuy Group currently works towards a political deal, which it is supposed to report to the European Council in October 2010. How do we evaluate these proposals in the light of the above considerations?

First, the need to improve national fiscal frameworks is well reflected. The European Commission proposals call for codifying the objectives of the EU fiscal framework into national law and for specifying minimum requirements for the design of domestic fiscal frameworks, ensuring that domestic fiscal frameworks reflect the Treaty obligations.

Second, European Commission (2010b, p7) mentions the need for independent forecasts, but we do not observe concrete steps yet towards making this point operational. In this respect, we note that the current proposal for the revised Code of Conduct still allows for national discretion on the institutional setting for making the forecasts (see the proposal for the revised Code, p. 5: “Member States are free to base their Stability/Convergence Programmes on their own projections”). This would leave an important source of fiscal bias unaddressed.

Finally, our research stresses that fiscal plans are highly visible to the public and the media, while implementation usually remains opaque. As a result, the political costs of biased planning are low, causing systematic biases to persist. The political costs of unrealistic projections could be raised by increasing transparency on these biases. Now that the Stability and Growth Pact has been in force for more than a decade, the Commission could use the information on fiscal planning for addressing systematic biases in specific countries.

The current proposals stress the need for better ex ante coordination and surveillance, by moving the submission of the Stability and Convergence Programmes to the Spring. At that time, fiscal projections are still very preliminary, i.e. not based on specific measures, and have not yet been submitted to the national Parliaments for approval. In our view, this is a positive move in strengthening the Commission’s influence at the planning stage. However, we believe that the current EC proposals should be complemented by reporting more explicitly on the eventual national budget law (as approved by Parliament), and a real-time (first-release) and an ex post assessment of its implementation over previous years. This will enhance transparency of the fiscal process and make the fiscal authorities more accountable. In general, a better recognition of the role played by the different budgeting stages – i.e. planning, implementation and ex post control – could help to align budgetary procedures at national level and at the EU level.

References

Beetsma, R, M Giuliodori, and P Wierts (2009), Planning to Cheat: EU Fiscal Policy in Real Time, Economic Policy, 24(60):753-804.

Beetsma, R, M Giuliodori, M Walschot, and P Wierts (2010), “Fifty Years of Fiscal Planning and Implementation in the Netherlands”, CEPR Discussion Paper 7969.

Debrun , X, L Moulin, A Turrini, J Ayuso-Calsals, and M Kumar (2008), “Tied to the Mast? The Role of National Fiscal Rules in the European Union”, Economic Policy, 23, 298-362.

EC (2010a), “Reinforcing Economic Policy Coordination”, 12 May.

EC (2010b), “Enhancing Economic Policy Coordination for Stability, Growth and Jobs – Tool for stronger EU Economic Governance”, 30 June.

EC, “Code of Conduct”, europa.eu.

Jonung and Larch (2006), “Improving Fiscal Policy in the EU: the Case for Independent Forecasts”, Economic Policy 21(47):491-534.

Topics: EU institutions, Global crisis, Macroeconomic policy
Tags: Eurozone crisis, fiscal policy

Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam

Massimo Giuliodori

Associate Professor, University of Amsterdam

Mark Walschot

Examining Officer at the Dutch Central Bank