Home Ratings and Research Research Strong fiscal rules in the EU do not guarantee good fiscal health
Strong fiscal rules in the EU do not guarantee good fiscal health
Monday, 21 January 2019

General government budget balance and stability in the EU

EU countries have developed the strongest global fiscal framework. They use three types of fiscal rules - budget rules setting limits on government structural deficits (typically 0.5% GDP), debt rules setting limits on debt-to-GDP-ratios (60%), and expenditure rules setting targets for the growth of government expenditures (based on the growth of potential GDP).

...driven by monetary union. Eurozone countries have stronger fiscal frameworks. They all have at least a budget rule incorporated in their national legislatures. Some non-eurozone countries voluntarily opted to join the eurozone fiscal framework. Three non-eurozone countries, however, have no adequate fiscal rules at all.

Strength of the fiscal rules is highest in Italy and Spain. Bulgaria and Estonia are in third place. The weakest frameworks are present in the United Kingdom and Hungary, which have no adequate fiscal rules at all.

...but compliance with those is the lowest. The compliance with fiscal rules is highest in Sweden followed by Malta and Ireland. The lowest compliance is in Italy, followed by France and Spain.

Strong debt rules do not guarantee sound public finances. The relationship between the strength of the debt rules and the compliance with the EU benchmarks is very weak. According to ERA's assessments, fiscal rule has a positive influence on sovereign creditworthiness but we also analyze the willingness of the governments to exploit the flexibilities of fiscal rules when assessing sovereign creditworthiness.

Governments are less willing to comply with fiscal rules when unemployment is high. Unemployment rate is the single biggest factor explaining the discrepancy between the fiscal rules strength and compliance with those fiscal rules.

Almost all of the EU countries have at least one adequate fiscal rule


The Stability and Growth Pact sets ceilings on deficits and debt-to-GDP ratios to 3% and 60%, respectively.


The eurozone sovereign debt crisis, which can be attributed to systematic non-compliance with the Stability and Growth Pact has created the need to implement stronger fiscal rules into the national legislations of eurozone countries. Since the onset of the debt crisis, all eurozone countries have adopted national debt rules. They were also joined by several non-eurozone EU countries.


In general, there are three main types of fiscal rules in the EU countries:

- Budget rules setting limits for government deficits;

- Debt rules setting limits for government debt-to-GDP ratios and the adjustment path if the debt is above the limit;

- Expenditure rules setting targets for annual government expenditures or multi-year expenditure ceilings.


The new EU fiscal framework, also known as the European Fiscal Compact, sets minimum benchmarks for these fiscal rules. For the budget rule, the threshold is set at structural deficit of 0,5%, for the debt rule at 60% of GDP and for the expenditure rule based on the growth rate of potential GDP.


The fiscal frameworks of EU countries are built on various combinations of these three types of rules, with the budget rule being the most prevalent. Nevertheless, compliance with these rules varies from country to country as a result of the political willingness to exploit their flexibilities. Therefore, the scope of this report is to assess not only the strength of the fiscal rules for each EU country, but also the degree of compliance with the same rules.


Map 1. EU countries by number of adequate[1] fiscal rule types

map_new


[1] ERA assesses a fiscal rule as inadequate when its threshold is not ambitious enough to lower the fiscal imbalances.

Surprisingly, the strongest fiscal rules are present in Italy and Spain


For more information regarding methodology, see appendix 1 on page 9.


Strength of the fiscal framework is assessed based on the number of fiscal rule types incorporated into national legislations and their strength relative to the thresholds specified in the European Fiscal Compact. The assessment is higher when the rule is embedded in the national constitution, which prevents a simple parliamentary majority from repealing or softening the rule.

The EU countries are divided into four groups based on the final score for the fiscal framework strength:

-        Very strong: above 0.75

-        Strong: 0.5-0.75

-        Moderate: 0.25-0.5

-        Weak: below 0.25

-        Very weak: 0


For information on country abbreviations used in the figures, see https://ec.europa.eu/eurostat/statistics-explained/index.php/Glossary:Country_codes

For scoring details, see appendix 3 on page 12.


Figure 1. Assessment of the fiscal framework strength in the EU countries

fig1

Source: ERA

The analysis of the fiscal rule strength shows only two countries in the “very strong” category – Spain and Italy. They are the only EU countries with all three types of rules incorporated into their constitutions. The strengthening of their fiscal frameworks was aimed at regaining the market confidence in their ability to service their sovereign debts during the debt crisis (2011 in Spain and 2012 in Italy).


This effort has proven unsuccessful and the European Central Bank (ECB) had to step in with a conditional guarantee of the eurozone sovereign debt to restore the market confidence.


The “strong” category consists of nine countries which have either all three fiscal rule types incorporated in their national legislations, or have only two of them, but with strong enhancements. The countries in this group can be further classified based on the following characteristics:

-        Countries with three rules compliant with the eurozone fiscal framework with no special enhancements - Ireland, Latvia, the Netherlands, and Romania (a non-eurozone country which opted to join the European Fiscal Compact).

-        Countries with three rules with some special enhancements. Austria has a slightly lower threshold of 0.45% GDP for the maximum structural deficit and Bulgaria has a 40% ceiling on public expenditures in addition to the expenditure rule based on the growth of the potential GDP.

-        Countries with two rules with major enhancements. Estonia has a structural balance target of zero and debt to GDP ceiling defined as percentage of revenue (40% for the central government and 60% for the local governments, which adds up to less than 20% of GDP), both embedded in constitution. Sweden (non-eurozone) aims for a structural surplus of 0,33% of GDP (1% before 2019) and has a constitutional multi-year expenditure ceiling rule. Finally, Slovakia has a constitutional debt rule with considerably lower debt target than the eurozone framework (the target has been declining since 2018 by 1 percentage point from 50% of GDP and should reach 40% in 2027).

For more information regarding methodology, see appendix 2 on page 10.

The “moderate” category consists of ten countries with either two fiscal rule types adopted or with only a budget rule with special enhancements. The countries in this group can be further classified based on the following characteristics:

-        Countries with two fiscal rules with no special enhancements – Denmark (non-eurozone), Finland, Portugal.

-        Countries with two fiscal rules with constitutional enhancements. Cyprus, Malta and Poland (non-eurozone) have constitutional debt rules and Lithuania has a constitutional budget rule (on the other hand, it has a somewhat weaker expenditure rule compared to the one specified in the eurozone framework).

-        Czech Republic, which has somewhat weaker budget rule (with a structural deficit floor of 1% GDP), but a slightly stronger debt rule (55% of GDP) compared to the EU framework

-        Countries with a budget rule with major enhancements. Germany has a constitutional structural deficit floor of 0.35% GDP and Greece has a massive primary surplus target of 3.5% GDP, this being a requirement of the bailout program.

The “weak” category consists of five countries with only one fiscal rule with no special enhancement. Belgium, France, Luxembourg and Slovenia have only a budget rule. Croatia, which is a non-eurozone country, has only an expenditure rule.

The “very weak” category consists of two countries with no adequate fiscal rules or none at all. Its members Hungary, and the UK, are non-eurozone EU members and therefore have no obligation to strengthen their fiscal frameworks.

Countries with strictest fiscal rules show the worst compliance

The soundness of public finances is assessed based on the compliance with the fiscal rules and in the case of non-compliance also by the adequacy of the annual adjustment towards the target. If the particular type of fiscal rule is not present in the national legislation or is considered inadequate, the compliance is tested against the thresholds specified in the eurozone fiscal framework. The assessment is carried out for a three-year period from 2017 to 2019. For 2018 and 2019, European Commission’s latest forecasts are used.


The EU countries are divided into four groups based on the final score for the fiscal rule compliance:

•          Strong: above 0.75

•          Moderate: 0.5-0.75

•          Weak: 0.25-0.5

•          Very weak: below 0.25


Figure 2. Assessment of the fiscal rule compliance in the EU countries

fig2

Source: ERA


For scoring details, see appendix 3 on page 12.


The assessment of the compliance with the fiscal rules shows a very different picture compared to the strength of the fiscal rules. The two countries with “very strong” fiscal frameworks show the lowest degrees of compliance with the rules and one country form the “very weak” category made it to the group with strongest public finances.

The "strong" group consists of seven countries showing strong compliance with budget and debt rules and mostly above average compliance with expenditure rules. Surprisingly, there are only three eurozone countries in this group – Ireland, Malta, and the Netherlands. The other two countries (Denmark and Bulgaria) voluntarily joined the European Fiscal Compact as non-eurozone countries. The remaining two countries, Sweden and the Czech Republic, are not bound by EU rules. Sweden's assessment of the fiscal rule strength was high and the Czech Republic's was moderate. This demonstrates that some governments can maintain healthy public finances even when they are not constrained by EU rules. The countries in this group can be further classified based on the following characteristics:

-        Countries with very strong growth levels in recent years (Ireland, Malta), which provides them with sufficient room to comply with fiscal rules;

-        Countries with long track-records of strong public finances – Bulgaria, Denmark, Sweden, the Czech Republic (all non-eurozone);

-        Netherlands, which shows strong commitment to adhering to fiscal rules in recent years.

-        The “moderate” group includes eleven countries, predominantly from the eurozone with strong adherence to at least one fiscal rule (mostly to the debt rule). The non-eurozone countries with moderate scores are Romania and Croatia, with Romania voluntarily opting to join the European Fiscal Compact. The countries in this group can be further classified based on the following characteristics:

-        Countries with low debt levels and above average GDP growth rates. These are mostly CEE countries (Estonia, Lithuania, Slovakia, Romania) together with Luxembourg. Their public finances are in sound shape and stronger growth creates more room for compliance with fiscal rules.

-        Countries with moderate fiscal imbalances and a moderate effort to lower them (Austria, Finland, Slovenia).

-        Germany and Cyprus, which show a strong commitment to adhering to fiscal rules in recent years, mainly in the form of solid structural surpluses. Germany is on track to lower its debt-to GDP ratio to below 60% up to 2019, while Cyprus has a debt-to-GDP ratio above 100% almost exclusively due to banking support measures, which is expected to decline significantly in the coming years.

The “weak” group consists of seven countries with lower degrees of compliance with fiscal rules, mostly with the budget rule. The countries in this group can be further classified based on the following characteristics:

-        Non-eurozone countries which did not join the European Fiscal Compact (Hungary, Poland, the UK).

-        Eurozone countries with weaker public finances (Belgium, Greece, Portugal)

-        Latvia, whose fiscal position has been recently weakened due to pension and healthcare systems reforms. Latvia was granted a temporary deviation from the EU rules due to these reforms. Its debt-to-GDP ratio remains, nevertheless, in a comfortable zone below 40%.


Spain and Italy, together with France, are the only three EU countries with “very weak” score for compliance with fiscal rules. Their compliance with the budget and debt rules is minimal, while their scores for expenditure rules are below average. In ERA’s view, the main reason for this phenomenon is the ECB’s conditional debt guarantee, which substantially lowers the market pressure to reduce the fiscal imbalances. This is also demonstrated by the latest measures planned in both Italy and France.

Strong fiscal rules do not guarantee sound public finances in the EU

The last part of the analysis is devoted to comparing the strength of and the compliance with fiscal rules. Figure 3 shows an almost flat trendline, i.e. there is no relationship between these two scores. The conclusion is that strong fiscal rules in the EU do not guarantee healthy public finances, mainly due to flexibilities of these rules which can be exploited if the governments want to pursue looser fiscal policies. The possibility to exploit these flexibilities is enhanced by the ECB’s conditional guarantee of the eurozone sovereign bonds, which substantially weakens the market pressure for the eurozone countries to conduct sound fiscal policies.


Figure 3. Relationship between the strength and compliance of fiscal rule

fig3

Source: ERA


Even when we eliminate the biggest outliers (Spain and Italy) from the analysis, together with the countries with no fiscal rules, the R-squared value shows that only 9% of the variation in compliance with the fiscal rules can be explained by their strength. This is a case for caution when assessing the fiscal rules without assessing the willingness of the governments to comply with them.


Figure 4. Relationship between the strength of the fiscal rule and the compliance (with outliers eliminated)

fig4

Source: ERA


Further analysis shows that the single biggest factor behind the variation of the relationship between the strength and compliance of fiscal rules is the unemployment rate. Variation of the deviation from the trendline from chart 3 explained by the unemployment rate is 28% for the whole sample. After eliminating countries which are not bound by the European Fiscal Compact, this figure increases to 44%. This implies that countries with higher unemployment rates are more likely to exploit the flexibilities within their fiscal rules.


The analysis also showed a non-negligible relationship between the deviation from the trendline in chart 3 and projected GDP growth in the 2017-2019 period (R-squared of 15% for the whole sample and 30% for the countries bound by the European Fiscal Compact) and the World Bank governance indicators (R-squared of 18% for the whole sample and 15% for the countries bound by the European Fiscal Compact). Unemployment, however, remains by far the strongest factor contributing to the deviation.


Figure 5. Relationship between the deviation from the fiscal rules strength/compliance trendline and unemployment rate for countries bound by the European fiscal framework

fig5

Source: ERA

Appendix 1: Methodology for the fiscal rule strength assessment

The starting point of the strength analysis of the fiscal rules is the eurozone fiscal framework[2] , which states the following:

- Budget rule: General government budgets shall be balanced or in surplus. This principle shall be deemed respected if, as a rule, the annual structural deficit does not exceed 0.5% of nominal GDP.

- Debt rule: Member States whose government debt-to-GDP ratio exceeds the 60% reference level in the latest recorded fiscal year, shall reduce it at an average rate of at least one twentieth (5%) per year of the exceeded percentage points.

- Expenditure rule: Spending increases which go beyond a country's medium-term potential economic growth rate must be matched by additional discretionary revenue measures.

The strength of each type of fiscal rule (in the range between 0 and 1) is assessed as follows:


Table 1. Assessment of the fiscal rule strength

 

Score

Fiscal rule is in compliance with the eurozone fiscal framework

Base score of 0.6 pts.

Fiscal rule is not in compliance with the eurozone fiscal framework, but it can have significant impact on public finances

Base score of 0.3 pts.

Fiscal rule is embedded in the constitution and cannot be changed by a simple parliamentary majority

0.2 pts. added

Fiscal rule is stronger than the eurozone fiscal framework

Up to 0.2 pts. added[3]

Weak fiscal rule[4] or no fiscal rule at all

0 pts.



[2] The central element of the eurozone fiscal framework is the so called “European Fiscal Compact.“

[3] Based on the degree of strength of the national thresholds compared to the eurozone rules.

[4] Fiscal rules are considered weak when their thresholds are not ambitious enough to lower the fiscal imbalances.

The final assessment of the fiscal rule strength is the average of the scores for the budget rule, debt rule and expenditure rule.

Appendix 2: Methodology for the assessment of the compliance with the fiscal rules

The starting point of the analysis of the degree of compliance with the fiscal rules are the thresholds specified in the eurozone fiscal framework:

- Budget rule: Structural deficit not exceeding 0.5% of nominal GDP;

- Debt rule: Debt-to-GDP ratio below 60%;

- Expenditure rule: Expenditure growth not exceeding the potential GDP growth rate.


The budget rule compliance assessment is based on the comparison of the structural balance with the national budget rule and, in the case of non-compliance, also by the degree of annual adjustment towards the target. Exemptions (both positive and negative) granted by the EU are not taken into account. The same applies to the higher permissible levels of structural deficits when the debt-to-GDP ratios are low. For countries with weak budget rules or no budget rules at all, the compliance is tested against the levels specified in the eurozone fiscal framework. The final score (in the range between 0 and 1) is assigned as follows:


Table 2. Budget rule compliance assessment

 

Score

Budget rule is met[5]

Base score of 0.75 pts.

0.05 pts. added per each 0.1% of GDP above the target up to 0.25 pts.

Budget rule is not met, but the structural deficit is close to the target

0.05 pts. added per each 0.1% of GDP above the target less 0.5% of GDP up to 0.25 pts.

Budget rule is not met, but the annual adjustment is at least 0.5% of GDP[6]

Base score of 0.25 pts.

0.05 pts. added per each 0.1% of GDP above the adjustment benchmark up to 0.25 pts.

Budget rule is not met, but the annual adjustment is close to 0.5% of GDP

0.05 pts. added per each 0.1% of GDP above the adjustment benchmark less 0.5% of GDP up to 0.25 pts.


[5] In the case of a very strict rule for countries with debt below 60% of GDP which calls for structural surpluses, the rule is considered to be met when the structural budget is at least balanced.

[6] According to the European Fiscal Compact, the adjustment path towards reaching a medium-term objective shall at minimum entail annual structural deficit improvements of 0.5% of GDP. Exemptions granted by the EU (both positive and negative) are not taken into account.


The debt rule compliance assessment is based on the comparison of the debt-to-GDP ratio with the national debt rule and, in the case of non-compliance, also by the level of the annual adjustment towards the target. For countries with weak debt rules or no debt rules at all, the compliance is tested against the levels specified in the eurozone fiscal framework. The final score (in the range between 0 and 1) is assigned as follows:


Table 3. Debt rule compliance assessment

 

Score

Debt rule is met

Base score of 0.75 pts.

0.05 pts. added per each 3% of GDP below the target up to 0.25 pts.[7]

Debt rule is not met, but the debt is close to the target

0.05 pts. added per each 3% of GDP below the target plus 15% of GDP up to 0.25 pts.

Debt rule is not met, but the annual adjustment is at least 1/20 per year of the exceeded percentage points[8]

Base score of 0.25 pts.

0.05 pts. added per each 1% of GDP below the adjustment benchmark up to 0.25 pts.

Debt rule is not met, but the annual adjustment is close to 1/20 per year

0.05 pts. added per each 1% of GDP above the adjustment benchmark plus 5% of GDP up to 0.25 pts. Debt-to-GDP ratio must be declining.


[7] In the case of a very strict rule for countries with debt below 30% of GDP, the maximum score of 0.25 is given.

[8] The 1/20 benchmark is calculated from the average debt to GDP ratio over the past three years.


The expenditure rule compliance assessment is based on the comparison of the nominal expenditure growth with the potential nominal GDP growth. Exemptions (both positive and negative) granted by the EU are not taken into account. The final score (in the range between 0 and 1) is assigned as follows[9]:


[9]
The EU does not assess the compliance with the expenditure rule in isolation, but with respect to the compliance with the budget rule. Therefore, the assessment differs from EU methodology.


Table 4. Expenditure rule compliance assessment

 

Score

Potential GDP growth exceeds expenditure growth by 1.5 percentage points

1 pt.

Potential GDP growth exceeds expenditure growth by 1-1.5 percentage points

5/6 pts.

Potential GDP growth exceeds expenditure growth by 0.5-1 percentage points

2/3 pts.

Potential GDP growth less expenditure growth is in the range between -0.5 and 0.5 percentage points

0,5 pts.

Expenditure growth exceeds potential GDP growth by 0.5-1 percentage points

1/3 pts.

Expenditure growth exceeds potential GDP growth by 1-1.5 percentage points

1/6 pts.

Expenditure growth exceeds potential GDP growth by 1.5 percentage points

0 pts.


The assessment is carried out for a three-year period from 2017 to 2019. The final score for the compliance with each of the fiscal rules is the average score for the 2017-2019 period. The assessment is based on the data from the European Commission's Autumn 2018 Economic Forecasts and from the European Commission's analysis of the 2019 draft budgetary plans.


The final assessment of the fiscal rule compliance is the average of the scores for the budget rule, debt rule and expenditure rule.

Appendix 3: Scoring details


Table 5. Detailed fiscal rules strength assessment

Country

Budget rule

Debt rule

Expenditure rule

Total Score

Austria

0.65

0.6

0.6

0.62

Belgium

0.6

0

0

0.2

Bulgaria

0.6

0.6

0.8

0.67

Croatia

0

0

0.6

0.2

Czech Republic

0.3

0.65

0

0.32

Cyprus

0.6

0.8

0

0.47

Denmark

0.6

0

0.6

0.4

Estonia

1

1

0

0.67

Finland

0.6

0

0.6

0.4

France

0.6

0

0

0.2

Germany

0.9

0

0

0.3

Greece

0.8

0

0

0.27

Hungary

0

0

0

0

Ireland

0.6

0.6

0.6

0.6

Italy

0.8

0.8

0.8

0.8

Latvia

0.6

0.6

0.6

0.6

Lithuania

0.8

0

0.5

0.43

Luxembourg

0.6

0

0

0.2

Malta

0.6

0.8

0

0.47

Netherlands

0.6

0.6

0.6

0.6

Poland

0

0.8

0.6

0.47

Portugal

0.6

0.6

0

0.4

Romania

0.6

0.6

0.6

0.6

Slovakia

0.6

1

0

0.53

Slovenia

0.6

0

0

0.2

Spain

0.8

0.8

0.8

0.8

Sweden

0.8

0

0.8

0.53

United Kingdom

0

0

0

0


Table 6. Detailed fiscal rules compliance assessment

Country

Budget rule

Debt rule

Expenditure rule

Total Score

Austria

0.4

0.52

0.72

0.55

Belgium

0.2

0.23

0.72

0.39

Bulgaria

1

1

0.33

0.78

Croatia

0.65

0.48

0.83

0.66

Czech Republic

1

1

0.28

0.76

Cyprus

1

0.25

0.28

0.51

Denmark

1

1

0.44

0.81

Estonia

0.17

1

0.39

0.52

Finland

0.48

0.67

0.89

0.68

France

0.12

0.03

0.5

0.22

Germany

1

0.75

0.44

0.73

Greece

0.67

0

0.39

0.35

Hungary

0.15

0.3

0.5

0.32

Ireland

0.85

0.7

1

0.85

Italy

0.02

0

0.33

0.12

Latvia

0.03

1

0.44

0.49

Lithuania

0.43

1

0.5

0.64

Luxembourg

1

1

0.11

0.7

Malta

1

0.95

0.61

0.85

Netherlands

0.95

0.85

0.67

0.82

Poland

0.03

0.9

0.17

0.37

Portugal

0.23

0.22

0.5

0.32

Romania

0.03

1

0.67

0.57

Slovakia

0.35

0.90

0.89

0.71

Slovenia

0.33

0.58

0.83

0.58

Spain

0.1

0.18

0.44

0.24

Sweden

1

1

0.61

0.87

United Kingdom

0.33

0.22

0.78

0.44

Appendix 4: References

European Commission. 2018. Autumn 2018 Economic Forecast. [https://ec.europa.eu/info/business-economy-euro/economic-performance-and-forecasts/economic-forecasts/autumn-2018-economic-forecast_en]. Acessed December 8, 2018.

European Commission. 2018. Draft Budgetary Plans 2019. [https://ec.europa.eu/info/business-economy-euro/economic-and-fiscal-policy-coordination/eu-economic-governance-monitoring-prevention-correction/stability-and-growth-pact/annual-draft-budgetary-plans-dbps-euro-area-countries/draft-budgetary-plans-2019_en]. Acessed December 8, 2018.

European Commission. 2017. Fiscal Rules Database. [https://ec.europa.eu/info/publications/fiscal-rules-database_en]. Acessed December 8, 2018.

European Commission. 2017. The Fiscal Compact – Taking Stock. [https://ec.europa.eu/info/publications/fiscal-compact-taking-stock_en]. Acessed December 8, 2018.

European Council. 2011. Official Jornal of the European Union, volume 54. [https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L:2011:306:FULL&from=EN]. Acessed December 9, 2018.

International Monetary Fund. 2018. World Economic Outlook Database, October 2018. [https://www.imf.org/external/pubs/ft/weo/2018/02/weodata/index.aspx]. Acessed December 8, 2018.

Lledó, V., S. Yoon, X. Fang, S. Mbaye, and Y. Kim. 2017. Fiscal Rules at a Glance. [https://www.imf.org/external/datamapper/fiscalrulesFiscal%20Rules %20at%20a%20Glance%20-%20Background%20Paper.pdf]. Acessed December 8, 2018.

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