The Eurozone crisis has compelled several European governments to undertake sizeable fiscal corrections in the midst of a severe recession. These countries lacked the “fiscal space” to respond to the crisis, as Spilimbergo et al (2008) would call it.
The lesson to be drawn is that fiscal policy during normal times must be sufficiently sustainable and counter-cyclical to enable aggressive fiscal intervention in the event of a major negative shock. A re-evaluation of the cyclical behaviour of fiscal policy is especially important for members of the Eurozone, since fiscal policy is the main tool available to deal with country-specific shocks.
One priority in re-designing the conduct of fiscal policy during “normal” times is to expand the scope of fiscal stabilisation policy. The traditional focus has been on GDP cycles, but fluctuations in asset markets and the sectoral composition of output are also relevant in determining the optimal stance for fiscal policy.
Cyclical tax receipts
Tax revenues are sensitive to the distribution of output across different sectors. For instance, the UK was heavily reliant on tax receipts from financial services’ high profits and high incomes. In the Irish case, tax revenues during the 2002-2007 boom were highly reliant on transactions-based taxes in the property sector. Capital gains tax receipts were also high during a period of rapid property price appreciation.
More generally, high asset prices can amplify tax revenues through several channels.
- Capital gains and wealth taxes increase with asset prices.
- High asset prices also boost consumption, and thus VAT receipts, through positive wealth effects.
- Rising asset prices often fuel high turnovers in asset markets and thus boost revenue from transactions taxes.
Accordingly, the optimal fiscal balance is not just a function of the output gap. Fiscal policy should account for the transitory nature of tax revenues stemming from rapidly inflating asset prices or disproportionate growth of high-income sectors.
Under such conditions, a more cautious approach would be to run larger fiscal surpluses in view of the temporary nature of windfall revenues and the risk of "sudden stops" in activity level in such sectors.
The importance of private debt developments
A related point is that risks to the fiscal position may arise due to the accumulation of balance sheet risks in the private sector. A previously healthy public balance sheet may rapidly deteriorate due to rescue operations that transfer private assets and liabilities to the public sector. In some cases, the costs of such bailouts may feed directly into public debt holdings. In other cases, the main liabilities may remain "off balance sheet" as guarantees or insurance to private entities. Under either scenario, the impact on the public balance sheet may affect funding costs for the government and affect choices over public spending and taxation.
Ireland’s government, for example, ran a solid surplus during the boom years, driving down its debt-to-GDP ratio from almost 50% in 1999 to 25% in 2007. This public rectitude, however, was paralleled by a private leveraging spree. When the banking system had to be rescued, Ireland’s public–debt-to-GDP ratio soared.
Excessive external imbalances
Fiscal policy should also take into account the risks associated with excessive external imbalances. Monetary unions are subject to a perverse “real interest rate” mechanism, whereby the common nominal interest rate is translated into a national real interest rate using the national inflation rate. Ireland, for example, ran inflation that was consistently above the Eurozone average, so its real interest rate was consistently lower. In such cases, national fiscal policy could be used to offset this sort of unintentional monetary stimulation, or stimulation arising from underlying distortions in the economy such as a housing bubble. When fiscal policy fails to offset this, it is contributing to the emergence of external imbalances. Regardless of the source of an external imbalance, fiscal policy may have a role to play in the external adjustment process.
A broader use of fiscal stabilisation policy
For these reasons, the scope of fiscal stabilisation policy needs to be expanded to recognise that fiscal sustainability is sensitive to boom-bust cycles in asset markets and balance-sheet fragility in the banking sector, other private sectors, and the external account.
The optimal fiscal surplus during good times should be determined by examining the sectoral composition of output in addition to the overall level. In addition, a nation’s fiscal stance should take into account financial and external imbalances that may be accumulating in the economy. Flanking policies may also be required to deal with such events. Governments have to selectively deploy fiscal instruments (such as taxes on the size of bank balance sheets or transactions taxes in the housing sector) to reduce the exposure to the fiscal risks associated with banking sectors and asset markets.
Independent advice and analysis for non-political experts
This wider scope for fiscal stabilisation policy reinforces the importance of designing a fiscal policy process that benefits from the substantial input of fiscal, macroeconomic, and financial experts. It is very difficult for political systems to make robust judgements on the appropriate cyclical stance of fiscal policy without an explicit role for expert input. To this end, an independent fiscal council can help identify the stabilisation risks facing the economy, estimate the appropriate cyclical position for the annual budget, and estimate the optimal future path of fiscal balances that will ensure fiscal sustainability.
Rules and flexibility
The role of an independent fiscal council may be complemented by formal fiscal rules that specify the medium-term path for the structural fiscal balance. However, a structural balance fiscal rule should contain an escape clause by which discretionary fiscal interventions are permitted in the event of a sufficiently large macroeconomic shock.
Such an escape clause provides the flexibility to address major recessions or (in the other direction) overheating episodes, which may require extra fiscal measures beyond the automatic stabilisers that are part of the passive cyclical component of the budget. However, in order to ensure that the escape clause is only triggered in episodes of genuine severity, the triggering of the escape clause should be the responsibility of the independent fiscal council rather than the political system.
In addition, the independent fiscal council could contribute to the transparency of the fiscal process by acting as an independent monitor of the quality and availability of fiscal data. It could also promote a public debate on fiscal policy through engagement with parliamentary committees, media, and the organisation of policy workshops.
It is important to emphasise that the establishment of a fiscal framework does not constrain the fundamentally political nature of decisions over public spending and taxation. In particular, medium-term fiscal sustainability is consistent with a wide range of public spending levels – it just requires that the trend component of public spending is matched by a corresponding level of trend revenue streams.
Accordingly, if the politically supported ratio of public spending to GDP shifted from one level to another, this can be accommodated by the specification of a transition plan that specifies how revenues will be adjusted to match the new desired level of government expenditure.
Independent but accountable
While independence of such fiscal policy councils is critical – for the same reasons that justify the independence of central banks – it is also vital that the fiscal councils be accountable. Accountability can be made effective by a two-track process.
- First, the members of the fiscal policy council should testify before the relevant parliamentary committees on a regular basis and explain clearly any errors in the projections made by the council.
- Second, the technical quality of the work produced by the fiscal council should be audited by regular reviews carried out by an international expert group.
Moreover, if each member country has an independent fiscal council, cooperation across these independent fiscal councils in developing best-practice analytical frameworks may be an effective mechanism to improve the quality of cross-country surveillance and mutual understanding of fiscal positions across the Eurozone.
The latest crisis has shown that fiscal policy is a vital element of any Eurozone members’ policy mix. The crisis has also driven home the complexities of analysing fiscal sustainability in a world where revenue can be affected by asset booms and busts and transitional growth of high-income sectors. The solution to these problems is to set up fiscal councils in Eurozone member states. These should be independent and accountable. Cross-Eurozone cooperation by such national fiscal councils would be an effective mechanism for surveillance and the development of mutual trust.
Lane, Philip R. (2010a), “Some Lessons for Fiscal Policy from the Current Crisis,” in preparation for the Nordic Economic Policy Review.
Lane, Philip R. (2010b), “External Imbalances and Fiscal Policy,” IIIS Discussion Paper No. 314.
Spilimbergo, Antonio, Steven Symansky, Olivier Blanchard and Carlo Cottarelli (2008), "Fiscal Policy for the Crisis," IMF Staff Position Note No. 08/01.