Fabrizio Balassone Econpubblica – Università Bocconi Milano, 25 Marzo 2009

1. Strenghtening Medium-Term Fiscal Frameworks Fabrizio Balassone Econpubblica – Università Bocconi Milano, 25 Marzo 2009

2. MTFF: definition & purpose • definition: set of institutions, procedures and rules governing (constraining) the development of public finances over the medium term • purpose: ensure fiscal discipline (sustainability & stabilization) • and efficient use of resources • work on MTFF combines economics, institutional knowledge and • a fair dose of pragmatism

3. Fiscal discipline means... • maintaining a prudent budget balance to: • ensure sustainability of public debt • allow margins to face cyclical fluctuations and • e unforeseeable events taking into account the • degree of debt tolerance • (Kumar & Ter-Minassian, IMF 2007)

4. Why budget discipline and efficiency? • fiscal discipline and efficiency maximize public sector (PS) • contribution to economic growth and welfare • fiscal discipline = prerequisite to PS functions • budget constraint is nec. cond. for allocative efficiency • low debt  no financial fragility  margins for stabilization • efficiency + stability  growth  resources for redistribution • NB discipline does not imply efficiency: need accountability • budget transparency (informed and explicit choices) • measurability of results (assessment)

5. Spreads (Spilimbergo et al. IMF09) 350 Long-Term Government Bond Yield Spread vis-à-vis Germany 300 Greece Ireland 250 200 Portugal Basis points Italy 150 Austria Spain Belgium 100 Finland Netherlands 50 France 0 1/1/07 3/12/07 5/21/07 7/30/07 10/8/07 12/17/07 2/25/08 5/5/08 7/14/08 9/22/08 12/1/08 2/9/09

6. The building blocks of a MTFF • a stable long-term anchor for the public finances rooted in some measure of sustainability • a simple medium-term “rule” ensuring consistency between the fiscal stance and the long-term anchor • a transparent convention on the headroom to build into the fiscal balances to deal with adverse circumstances • a multi-year budget with top-down preparation and tight execution procedures • mechanisms to ensure prudent forecasts of macroeconomic and fiscal variables • reporting, monitoring, auditing tools to ensure accountability

7. OUTLINE • Why discretion needs to be constrained • Issues in building a MTFF (and solutions?) • A few remarks about Italy • Summary

8. Why Does Discretion Need to Be Constrained?

9. The political economy of budget deficits • opportunistic politicians & naive voters (Puviani, 1903; Buchanan & Wagner, • AEI 77; Buchanan et al., 1986) • variation 1: myopic politicians (Alesina & Tabellini, RES 1990; Rogoff, AER 1990) • variation 2: intergenerational distribution(Browning, EI 75; • Tabellini, NBER 90, JPE 91; • Cuckierman & Meltzer, AER 89) • time inconsistency (Kydland & Prescott, JPE 77; Eichengreen et al., OER 99) • common pool (Eichengreen et al., OER 1999; Velasco, 1999) • variation 1: federalism(Buchanan, 1967; Oates, 1979; Weingast et al. JPE81) • variation 2: monetary union (Balassone & Franco, JPFPC02) • strategic use of the budget (Persson & Svensson, QJE 89; Alesina & Tabellini, RES 90; • Tabellini & Alesina, AER 1990) • coalitions & wars of attrition(Roubini-Sachs, EP89; Alesina-Drazen, AER91; Balassone-Giordano, PC01)

10. Some evidence of the propensity to deficit finance

11. It gets worse in good times • “voracity effect”: perverse interaction between abundance of • resources and political economy factors (common pool, myopia…) • (Lane & Tornell, AER 1999; Debrun, Hauner & Kumar, IMF 2007) • growing supporting evidence (asymmetric procyclicality) • (Buti et al. OREP98; Buti & Sapir 1998; Balassone & Francese, TD04 & TD08; European Commission, 2006) • coming mostly from expenditure • (Kaminsky et al., NBER04; Hercowitz and Strawczynski, RES04; Balassone, Francese, Zotteri, TD08)

12. Can we rely on markets? • Theory • (Bishop et al., 89; Lane, SP 93) • No privileged access • Full information • No bail-out • Timely Signals • Sensitivity to signals • Practice • CB Independence • Issue of information quality remains • (Balassone, Franco, Zotteri, E06) • Credibility of the clause? (IMF97) • Not always (Ferri et al., EN99) • Low and delayed • (Balassone, Franco, Giordano, BI04) Fitch Ratings (2004) : “15-20 basis points […] is perhaps the most that could be attributed to credit differentials between AAA and AA euro-area governments [and] such amounts hardly seem likely to keep a German finance minister awake at night” (p. 6).

13. The quality of information

14. The quality of information

15. II. Issues in Building a MTFF

16. The broad definition of fiscal discipline • fiscal discipline = prudent budget balance to: • ensure sustainability of public debt • allow margins to face cyclical fluctuations and • unforeseeable events taking into account the • degree of debt tolerance • Problems: • defining debt “sustainability” • forecasting/measuring the economic cycle and its effects on the fiscal balance • quantifying implications of unforeseeable events (e.g. contingent liabilities - IMF 2007) 4. estimating the degree of “debt tolerance” • (history? Reinhart, Rogoff & Savastano, NBER 2003)

17. Debt sustainability (Banca d’Italia, 2000, 2004, 2006) • intuition is clear: solvency  debt repayment // but timing? • limt→ dt = 0 • moreover, theory says otherwise: “no Ponzi-game” • limt→ dt [(1+)/(1+)]-t = 0  limt→ dt = | d’<(-) • (Blanchard et al. OECD90; McCallum, JPE84) • T<Y still leaves many options! • (Barro JEP89; Kremers JME89, Domar AER44)

18. Measuring the effects of the cycle • cyclically adjusted balance (cab) • cab = b - ε  •  = (y-y*)/y* •  =b/(y/y) = (R R/Y - G G/Y – b)  G/Y se R  1 e G  0 • (Bouthevillain et al., ECB 2001: EU avg.: 0.9 and -0.2) • problems • different estimation methods return different values of  • estimates of  subject to significant revisions (any method) • estimation of elasticities far from straightforward • is the output gap enough? (composition of output; other variables)

19. Dispersion in OG estimates • large in levels, less so in changes(Orphanides e Van Norden, RES 2002)

20. OG estimates: Dispersion and Revisions

21. Y* (hence CAB) = f (Y past & future) – therefore: - revisions of forecasts influence the assessment of past outturns - the effect can be large in the proximity of turning points Example: 2001 fiscal balances in France and Germany Why the revisions?

22. Elasticities • data intensive • institutional knowledge vs. econometrics • (reforms) • identification of macroeconomic proxies for tax bases • (e.g. profits)

23. Output composition • e.g. exports and domestic demand have different tax implications • (Momigliano & Staderini, BI98; Bouthevillain et al., ECB01; Marino et al., QEF08)

24. A pragmatic approach • In sum: theory does not provide full guidance in defining both the long-term anchor and the medium term rule for a MTFF • Need a pragmatic approach: • Define “prudent” debt levels somewhat ad hoc (UK-EU) but not too different from proposals by theorists (Blanchard ES90, Buiter EP85…) • Derive corresponding “structural” deficit targets - based on long-term expenditure projections -use sensitivity analysis (sustainability reports – Norway; EPC ageing working group 2006) • Define medium-term / “over-the-cycle” targets with escape clauses in the face of unfavorable circumstances • (Sweden; UK code of fiscal conduct; …)

25. A few examples

26. Rules = commitment-devices and signaling tools • (they increase the costs of deviating from the target for policymakers and • reduce public’s uncertainty about policymakers’ commitment) • Constrain the bias but mindful not to: • introduce excess rigidity and prevent adequate responses • (e.g. let automatic stabilizers play in bad times – balanced budget rule?), • force inadequate responses • (e.g. a fiscal contraction in response to a temporary spike in interest rate, or depreciation of the exchange rate), • Let the bias unchecked in specific circumstances • (e.g. allow for procyclical expansions – medium-term/over-the-cycle formulations like the (old?) SGP and UK code of fiscal conduct) The design of fiscal rules

27. Other issues of “design” • some rules are not targeted to fiscal discipline • (golden rule  sustainability) • window dressing (inconsistent deficit/debt indicators – SGP) • some rules cannot stand alone • (e.g. expenditure rules)

28. PROS: • provide a stronger link between the long-term anchor and • the multi-annual budget exercise • tackle the bias at source (expenditure) • let (revenue) automatic stabilizers play • BUT • cannot leave the revenue side unchecked • (tax expenditure) • MORE COMPLEX THAN IT SEEMS • what about automatic stabilizers on the expenditure side? • possible exploitation of planning margins? Expenditure rules

29. Tax expenditures - Sweden

30. Exploitation of planning margins - Sweden

31. III. Some Remarks about Italy

32. The long-term anchor and the fiscal stance • SGP: debt-to-GDP ratio = 60% but when? • (“satisfactory pace” never defined) • Often D/Y<100% targeted in official documents BUT on what basis? • No sustainability report – setting medium-term deficit target? • (long-term projections only for the EPC AWG)

33. The medium-term rule • EU: structural adjustment by ½ percent per year towards structural balance + free play of automatic stabilizers • Truly endorsed? • No explicit convention about headroom within the target

34. As a consequence…. (A) General Government debt and deficit (% of GDP)

35. As a consequence…. (B) Fonte: Banca d’Italia, Relazione Annuale 2007

36. Multi-year budget, top-down preparation, tight execution • No “true” multi-year budget • (3 years but t+1 and t+2 are forecasts, not binding plans) • No top-down budgeting • (no expenditure ceilings) • Rather lax execution • (no explicit contingency reserve but weak link between authorizations from the state budget and accounts relevant to the fiscal targets) • (possibility to use “windfall revenues” to increase expenditure)

37. As a consequence…. Contributions to deficit reduction (% PIL) Deficit reduction mostly from higher revenues and lower interest exp.

38. Prudent forecasts - Accountability • Insufficient information on fiscal projections on a current programs basis & on costing of new legislation • Difficult to assess outturn • No formal assignment of independent assessment • (plus nothing much happens if targets are not met) • Budget and legislation by line-items not programs • Not surprisingly the 2007/2008 spending review found abundant evidence of inefficiency in the use of public money • (CTSP08)

39. A few examples Ministry of Infrastructures – Regional Offices: staff per billion of assets (CTSP08)

40. A few examples Ministry of Justice – Prisons: Expenditure per inmate vs. number of inmates (CTSP08)

41. A few examples Ministry of Justice – Courts: Elasticity of scale (yertical) vs. Number of Judges (horizontal) – (CTSP08)

42. Education: resources vs. outcomes An inverse correlation between resources and outcomes (Montanaro, QEF08) Proficiency levels (primary and lower secondary schools (INValSI) Teachers per pupils Darker colors = higher values

43. Health Services: Resources vs. Activities Another inverse correlation (Francese & Romanelli, BI09) Expenditure per resident (adjusted for the composition of population) Patients’ mobility Darker colors = higher values

44. IV. Summary and Conclusions

45. 1. There are significant incentives to fiscal indiscipline (both theory and evidence) 2. This entails both macro-risks and micro inefficiency 3. MTFFs can help re-engineering incentives and control risks: they are not a magic wand but one is better-off having them (issues in design & enforcement) • Italy: EU fiscal rules provide a frame but content needs to be defined at the national level

46. 1st on the “to-do-list”: Improve Accountability • “Educate the public”: set credible objectives, openly discussed and clearly communicated to population at large (e.g. sustainability reports) • Ex post reconciliation of changes from one budget to the next • Parliamentary scrutiny of financial performance • Range of sanctions for persistent “overspenders”

47. What Others Do • EX ANTE • External scrutiny of economic assumptions (UK) • Use of consensus economic forecast (Canada) • Independent evaluation of macroeconomic conditions and fiscal stance (Sweden) • Independent fiscal forecasts (Netherlands) • EX POST • Transparent reporting of fiscal performance (UK, NZ) • Independent evaluation of fiscal compliance with objectives (Sweden) • Predetermined mechanisms for addressing deviations form forecasts (Switzerland)

48. Medium-term Expenditure FrameworksRange of Advanced Country Models 48

49. Effective Multi-year Expenditure Prioritization Mechanisms

50. Adjustment Mechanisms:Managing risks, pressures & shocks in a multi-year system • 3. Contingency Reserves • Building contingency margins into expenditure projections or ceilings: • Netherlands: 0.25% • UK: 0.75 – 1% • Canada: 1.5 – 2% • Sweden: 1.5 – 2% • Australia: 1.5 – 5% 1. Exclusion Excluding volatile/non-discretionary items from the rule celing, such as: • debt interest • unemployment benefits • social security • earmarked revenues • local government (own resources) 2. Adjustment Adjusting ceilings to accommodate real economy effects, such as: • inflation (Netherlands) • revenue windfalls (Netherlands, Canada) 4. Budget Architecture Capacity to absorb shocks: • max 20-30 main budget headings • each budget a mixture of discretionary and non-discretionary items • maximum flexibility to reallocate • ministerial contingency reserves • mandatory savings targets