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What are the best practices for designing and implementing fiscal rules to ensure fiscal sustainability?

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Fiscal rules are laws or regulations that constrain the fiscal policy of governments, such as limiting the budget deficit, the public debt, or the expenditure growth. They are often adopted to ensure fiscal sustainability, which means that the government can meet its current and future obligations without resorting to excessive borrowing or defaulting. But how can fiscal rules be designed and implemented effectively? Here are some best practices based on the experience and recommendations of international organizations and experts.

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1 Why fiscal rules matter

Fiscal rules can help governments achieve macroeconomic stability, fiscal discipline, and credibility. By setting clear and transparent targets and limits, fiscal rules can reduce uncertainty and volatility, enhance fiscal transparency and accountability, and signal the government's commitment to sound fiscal management. Fiscal rules can also support fiscal coordination and cooperation among different levels of government, especially in federal or decentralized systems.

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Christopher E.S. Warburton, Ph.D.

International Economist & Consultant
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Rules facilitate the proper allocation of funds to statutory requirements. Policymakers must be able to project the amount of revenue that should be allocated to discretionary spending, nondiscretionary spending, off-budget outlays, and incidentals. Fiscal rules necessitate revenue projections that are consistent with projected outlays; such rules must mandate the pursuit of essential revenues and an efficient infrastructure for revenue collection. Guiding rules require periodic evaluation of success or failures (shortfalls) that warrant readjustments or recalibration. Importantly, the rules must be realistic.

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David O'Rear

Author, "What's Wrong With Hong Kong (and, How to Fix it)
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The idea that certain barriers exist to keep government revenues and / or spending in check can be quite appealing, assuming that no emergencies arise. And, on the assumption that the underlying structure of the economy remains the same. As New York City discovered in the 1970s, and Hong Kong during SARS, these can be very dangerous assumptions to make.

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2 How to design fiscal rules

The design of fiscal rules depends on the specific objectives, constraints, and preferences of each country. However, some general principles can guide the process. First, fiscal rules should be consistent with the medium-term fiscal framework and the long-term fiscal sustainability. Second, fiscal rules should be simple, transparent, and easy to monitor and communicate. Third, fiscal rules should be flexible and adaptable to changing economic conditions and shocks. Fourth, fiscal rules should be comprehensive and cover all relevant fiscal aggregates and entities.

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David O'Rear

Author, "What's Wrong With Hong Kong (and, How to Fix it)
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As with any budget, there are two sides to the balance sheet: income and out-go. Both must be taken into consideration when considering the value of fiscal rules. On the income side, one type of fiscal rule is restrictive, capping the amount that might be taken out of the economy under any circumstances. An example is California's Prop. 13, which limits government income from real estate taxes. Another type of income rule is a stabilizer, which is designed to prevent an unusual change in economic circumstances (COVID, for example) from curtailing needed spending.

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Christopher E.S. Warburton, Ph.D.

International Economist & Consultant
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In designing fiscal rules, the rules must prioritize the categories of outlays and consider the proportion of projected revenues that must be allocated to each category of broadly defined outlays. Of course, nondiscretionary spending is usually superior to the other categories.

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3 How to implement fiscal rules

The implementation of fiscal rules necessitates strong institutional and political backing, as well as effective enforcement and compliance mechanisms. To ensure a successful implementation, it is essential to establish an independent fiscal council or agency to monitor, evaluate, and advise on fiscal policy and rules. In addition, creating a legal or constitutional basis for fiscal rules can increase their credibility and durability. Furthermore, developing a fiscal responsibility law or charter to define the objectives, scope, and procedures of fiscal rules, along with the sanctions and corrective measures for non-compliance is paramount. Additionally, building a broad consensus and ownership of fiscal rules among the public, the parliament, and other stakeholders is necessary. Lastly, providing adequate information and education on the benefits and costs of fiscal rules is essential.

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David O'Rear

Author, "What's Wrong With Hong Kong (and, How to Fix it)
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Given that all government activity is on behalf of the citizenry, the appropriate oversight for something as basic as public fiscal policy is the legislature. Independence may be highly valued in managing monetary policy, which is primarily reactive. But, fiscal policy includes the aspirations, expectations, and needs of the population. It would be entirely inappropriate to hand authority over such a basic governing authority to a non-governmental agency.

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Christopher E.S. Warburton, Ph.D.

International Economist & Consultant
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Procedural rules, transparency of transactions, and evaluative criteria of income and expenditures must be clearly established and understood. Spending must be specifically targeted without the specter of loose or unauthorized fungibility.

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4 How to evaluate fiscal rules

Evaluation of fiscal rules is necessary in order to assess their performance, impact, and relevance over time. It can also help to recognize the strengths and weaknesses of the existing framework and suggest potential reforms or adjustments. When evaluating fiscal rules, some criteria to consider include effectiveness, which looks at whether fiscal rules have achieved their intended objectives and contributed to fiscal sustainability and macroeconomic stability; efficiency, which examines whether fiscal rules have minimized the economic and social costs of fiscal adjustment and avoided distortions or trade-offs; compliance, which assesses whether fiscal rules have been respected and followed by the government and other fiscal actors; and credibility, which gauges whether fiscal rules have been viewed as binding and credible by the markets, the public, and the international community.

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Christopher E.S. Warburton, Ph.D.

International Economist & Consultant
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The use of outcomes assessment should be very helpful. Did spending and revenue projections achieve their targeted objectives? If not, why not? Is the public spending or revenue associated with undue lags or bottlenecks? Are there improprieties? Is the time horizon for expected results (acquiring money or spending) too short or overambitious? Was the spending or revenue adequate (robust) or inadequate? What are the extraneous circumstances that impacted the efficacy or inefficacy of public spending? The efficacy of rules must not be detached from targeted time horizons. What is the gestation period or expected time horizon for assessing the impact of the fiscal rules? How are the time dimensions defined or measured (operationalized)?

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5 How to reform fiscal rules

Fiscal rules are not static or immutable, and they may need to be reformed or revised to adapt to changing circumstances. For example, they may need to be updated to address new fiscal risks or vulnerabilities, such as aging populations, climate change, or health crises. Additionally, fiscal rules should incorporate new fiscal indicators or methodologies and align with fiscal objectives or priorities, such as green growth, social inclusion, or public investment. Moreover, they can be enhanced for credibility, flexibility, and transparency with escape clauses, adjustment factors, or reporting requirements. Nevertheless, fiscal rules are not a panacea or a substitute for sound fiscal policy; they are a tool to support and complement fiscal policy that requires careful design, implementation, evaluation and reform. By following the best practices outlined in this article, you can make the most of fiscal rules to ensure fiscal sustainability and macroeconomic stability.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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International Economics

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What are the best practices for designing and implementing fiscal rules to ensure fiscal sustainability?

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1 Why fiscal rules matter

2 How to design fiscal rules

3 How to implement fiscal rules

4 How to evaluate fiscal rules

5 How to reform fiscal rules

6 Here’s what else to consider

International Economics

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