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Symposium 2012

Background Paper - Fiscal Rules: Theoretical Issues and Historical Experiences

The Challenge

Large and growing ratios of public debt to GDP in many countries are demanding vigorous efforts to achieve fiscal consolidation. Many observers believe that a fiscal rule should be the central element ...

Large and growing ratios of public debt to GDP in many countries are demanding vigorous efforts to achieve fiscal consolidation. Many observers believe that a fiscal rule should be the central element of a successful strategy: they argue that a rule would restrict discretionary actions by governments, thereby strengthening the credibility of consolidation. But there are substantial differences of opinion on the precise specification of the rule.

Fiscal indiscipline is a feature of many developed countries. It is generally accepted that the source of the phenomenon lies in the common pool problem, the fact that recipients of public spending to fail to fully internalize the costs  that taxpayers must assume. As a result, democratically elected governments are led to postpone tax collection, or to cut spending. Solving the fiscal iscipline problem requires internalizing this externality. This calls for adequate institutions or for rules, or both. This paper reviews the various types of solutions that have been discussed in the literature and surveys a number of experiments. With the European debt crisis in mind, the paper pays particular attention to the common pool problem that emerges in federal states. The main conclusions are the following. First, rules are unlikely to exist unless they come with supporting institutions. Second, fiscal institutions are neither necessary nor sufficient to achieve fiscal discipline, but they help. Third, because  Institutions must bind the policymakers without violating the democratic requirement that elected officials have the power to decide on budgets, effective arrangements are those that give institutions the authority to apply legal rules or to act as official watchdogs.