Institutionalizing fiscal policy

Historically, while there has been a well-established architecture, both in terms of institutions and formal rules, for taking monetary policy decisions, none exists for fiscal policy actions. Interest rates are set by Central Banks (and their Monetary Policy Committees) using the standard Taylor Rule framework, or one of its variants, with reference to prevailing macroeconomic parameters like inflation and unemployment rates.

While price stability, embodied in low long-run inflation rates, is more or less an accepted part of public debates, debates about an acceptable level of public debt and deficits raise several controversies. Further, the re-distributional side of fiscal policy and its attendant political dimensions introduces a strong political economy aspect into fiscal policy decisions. Unlike the largely apolitical interest rate decisions, those on whom or what to tax (and their respective rates of taxation) and what and where to spend or cut expenditures are of deeply political nature.

The Great Recession and the resultant need for fiscal expansion, at a time when economies across the world are fiscally strained with massive and unsustainable debt burdens, has spot-lighted attention on the inadequacies of the standard fiscal policy toolbox. Unlike monetary policy, apart from being deeply political, fiscal policy decisions are mostly ad-hoc and piecemeal, with rarely any objective and independent assessment of future costs and returns.

In this context, at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Symposium, Eric M. Leeper argued about the need for both fiscal research and fiscal policy practice to becoming more scientific. He makes the striking point that while "the macro policy dimensions of monetary policy — output and inflation stabilization — have been largely depoliticized, virtually no aspect of fiscal policy is insulated from politics".

Leeper draws the distinction between micro fiscal decisions (that are ground out by the give and take of politics) and macro fiscal issues (that can be treated as primarily scientific matters), and argues that once the overarching macro issues are settled, the politically determined micro questions would be constrained. He poses a series of questions that fiscal policy makers should address in their quest to making their task more objective and scientific

1. Should there be a long-run target for the debt-GDP ratio? What should it be?
2. Are there circumstances under which deficits (surpluses) should be permitted to permanently raise (lower) the debt-GDP ratio or should debt always be retired back to some long-run target?
3. Should government spending, taxes, and monetary policy be adjusted to stabilize debt?
4. How rapidly should the debt ratio be retired back to the target ratio?
5. What are the macroeconomic effects of certain government spending and tax changes in well-specified thought experiments?
6. What are a country’s fiscal limits and how much government debt can it support before markets deem the debt to be risky?
7. What happens as the economy approaches its fiscal limit?
8. What policies can keep the economy well away from its limit?
9. What are the are the macroeconomic consequences of alternative policy responses to the era of fiscal stress?
10. Should monetary and fiscal policy behave in fundamentally different ways in an era of fiscal stress than they do in normal times?

Nominal fiscal rules that place targets on fiscal deficits and public debts are amongst the commonest and simplest form of scientific fiscal policy practice. Many countries, notably Chile, Sweden, and New Zealand have nominal targets on these fiscal parameters. The most famous example of such fiscal rule is the European Union's Growth and Stability Pact that prescribed clear fiscal deficit and public debt targets for members.

India too adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004, aimed at disciplining government expenditures. The FRBM mandated elimination of revenue deficit (by reducing it by 0.5% of GDP every year for five years beginning 2004-05) and fiscal deficit be lowered to 3% of GDP by 2008-09 (by annual reduction by 0.3% of GDP). The FRBM rules have mid-year targets for fiscal and revenue deficits, at 45% of budget estimates by the end of September each year. In case of a breach of either of the two limits, the Finance Minister will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit. See this excellent analysis of India's FRBM Act.

Fiscal councils are the other preferred institutional answer to the conduct of fiscal policy. Simon Wren-Lewis (via Amol Agarwal), who has an excellent website on Fiscal Councils, writes that such councils, which though funded by the government are independent, and provides macroeconomic policy advice, especially on the likely course of national budget deficits. They make the budget more transparent and credible, by providing independent analysis of the budget numbers, and checking the Government’s policy, budget projections, and growth assumptions for consistency.

It is believed that an independent fiscal council would promote counter-cyclical fiscal policies and reduce the deficit bias that governments are vulnerable to. They could provide independent and accurate (eliminating window dressing through off-balance sheet accounting) assessment of the current and future deficit projections implied by current policies. It would act as a possible restraint, working through public pressure and moral suasion, on the spending-happy, short-term biased populist governments. Further, it could also act as a "co-ordination mechanism that forces individual spending ministers to recognise the overall budget constraint".

Sweden, Hungary and Netherlands are among those with relatively well-functioning councils, though the US CBO has some of its features. Sweden has an independent fiscal policy council whose chair testifies before the Parliament, which in turn has succeeded in generating productive public debate about the trade-off between sustainability and fiscal stimulus, which the Swedish government and most others have been facing. In Netherlands, the government-run Central Planning Bureau (or Bureau for Economic Policy Analysis) has sufficient credibility as an independent evaluator that political parties feel compelled to have their fiscal plans vetted by the Bureau.

On similar lines, Tim Besley and Andrew Scott (via Amol Agarwal) have advocated setting up "independent fiscal policy committees to institutionalize fiscal transparency and restore credibility to governments’ long-term public finances", especially given the legacy of current expansionary policies and unsustainably large debts across many countries.

In the context of India, Niranjan Rajadhyaksha has argued for the establishment of a fiscal council, similar to the CBO, given the political difficulty of setting up any independent fiscal authorities. For a start though, the Finance Ministry would do well to try answering Eric Leeper's aforementioned set of ten questions.

Update 1 (22/4/2011)

Lars Calmfors and Simon Wren-Lewis argue that, with the right guarantees of their independence in place, independent fiscal councils can make a significant positive contribution to fiscal policy.