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19-09-2018

Valuable legacy? The effect of inherited fiscal rules

Author: Csaba G. Tóth

Published in: Public Choice | Issue 1-2/2019

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Abstract

The working mechanism of national fiscal rules depends strongly on whether a government must comply with its own rules or inherited ones. In the former case, a government usually introduces fiscal rules to show its commitment to a disciplined fiscal policy (the signaling function). In the latter context, however, inherited rules constitute external obstacles to budgetary policymaking (the limiting function). This study mainly is concerned with the limiting function and therefore bases its empirical analysis on periods when the ruling government inherited fiscal rules introduced by a previous government. The results of a panel-data econometric study indicate that national fiscal rules do contribute to disciplined fiscal policy after a change in government in times of an economic upturn. That finding, however, does not mean that the signaling function is ineffective: quite the contrary. My results, in line with the literature, indicate that the double functions of rules may complement one another. A government that introduces such rules is often already committed to a disciplined policy and wishes to signal such commitment in the short term. With the appearance of new government, however, the function of rules changes, and they efficiently promote disciplined fiscal policy in the long term.

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The actual goal of fiscal rules may differ from country to country, but as I refer to it later, one of the main goals is to ensure macroeconomic stability by restraining deficit bias (Kennedy and Robbins 2001).

A new approach was introduced by Grembi et al. (2016), who applied a quasi-experimental method to study the effects of fiscal rules among local governments in Italy.

Notably, just as Persson and Svensson (1989) emphasized that (building up the) public debt can be a tool in the hands of the departing government to limit the fiscal space of its successor, the same is true of fiscal rules. If the government is unlikely to win in the next election, decision makers can be motivated to complicate the fiscal situation faced by the next government by creating new budgetary rules.

To be comparable to the literature, I also carried out our estimations in terms of the cyclically adjusted primary balance, and I obtained similar results.

The FRI is the simple sum of FRSI by year and by country computed such that at the last step of aggregation, the complete database, ranging from the first year to the last one, is transformed into a zero-mean, one-standard-error distribution. The smallest possible value of the index is − 1.01 when no fiscal rule is in force in a country in a given year, whereas the largest value is 2.13.

Bergman et al. (2016) used the database containing the International Monetary Fund's (IMF’s) budgetary rules and concluded that fiscal rules are able to reduce structural public budget deficits.

The picture that Heinemann et al. (2014) draw is made more ambiguous by empirical evidence suggesting that fiscal rules can contribute to reducing risk premiums in countries with rather weak cultures of stability.

I intentionally ignore the fiscal rules of the EU itself, mainly because the nature of those rules differs from the nature of national rules in many aspects (legal background, validity and the like). However, later in the regression estimations, I use a variable (EURO) that captures the effort of member countries to pursue disciplined fiscal policy in order to adopt the euro as their national currency in 2001. As the numerical details of the necessary fiscal conditions for joining the eurozone are contained in the Maastricht Treaty, from 2001 on, I consider those supranational rules, which turn out to have had the strongest influence on public budget balances in the investigated period.

Similar to our study, the primary balance also is used by Marneffe et al. (2010), Afonso and Hauptmeier (2009) and Cordes et al. (2015).

In the cases of Austria, Bulgaria, Estonia, Latvia and Portugal, my questions were answered with the help of a coworker, the leader of the local fiscal council or central bank, or a local economist with expertise in national fiscal policy.

Certainly, the size of the fiscal expansion must also be limited during crises, but so far, no consensus has emerged about the threshold, which makes it difficult to evaluate the efficiency of fiscal rules from that perspective. For more details on the mechanism of fiscal rules in recessions, see Hong (2015).

Fiscal rules may incentivize decision makers to comply with the rules through informal methods (e.g., creative accounting, manipulating), but in this paper, we can measure only the consequences that are captured by a fiscal balance indicator.

The results do not change if the threshold value is 0, as I will show below.

The description of the index is summarized in Sect. 2.

Estimated with a Hodrick–Prescott filter (Source: AMECO).

To check the potential bias caused by different measures of GDP in both the dependent and explanatory variables, I considered different specifications with different dependent variables. First, I used the primary balance of trend GDP instead of the primary balance of GDP; second, I used the primary balance per capita in millions of euros. The qualitative conclusions from the model did not change, as the FRI remained significant.

As in the case of cross-section regression to check the potential bias that may be caused by measures of GDP in both the dependent and explanatory variables, I examined different specifications with different dependent variables for all observations. First, I used the primary balance of trend GDP instead of the primary balance of GDP; second, I used public balance per capita in millions of euros. The qualitative conclusions from the model did not change, as the FRI remained significant.

The sum of the FRI and the coefficients of the interaction did not prove to be significant in this case, so their sum cannot be interpreted.

The sum of the two coefficients also proved to be significant (P = 0.006).

The sum of the FRI and the interaction coefficient was not significant.

Because of multicollinearity, I ran the regression by omitting FRI and GAP3 from the right-hand side of the equation; in that case, their interaction (FRI * GAP3) was still significant, and the coefficient was 0.96.

In the first step, I used the Database of Political Institutions 2015 (Cruz et al. 2016) and computed a dummy variable to capture the government’s ideology. The size and significance of the coefficient of the interaction remained the same (see the results reported in Table 8 in Appendix). To check my findings, I repeated the estimation with a new variable from another dataset. The Comparative Political Data Set 1960–2014 (Armingeon et al. 2017) contains a variable that measures the cabinet posts of right-wing parties as a percentage of total cabinet posts. The findings were the same: the size and significance of the interaction of the FRI and GAP3 remained unchanged.

The results of the estimation of the basic model as well as the estimation without the interaction term are found in Table 9 in Appendix.

The interaction coefficient was 0.96 and significant. Detailed results are shown in Table 10 in Appendix.

As with all other studies in the literature, they combined all kinds of fiscal rules, including both inherited and own rules.

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Title: Valuable legacy? The effect of inherited fiscal rules
Author: Csaba G. Tóth
Publication date: 19-09-2018
Publisher: Springer US
Published in: Public Choice / Issue 1-2/2019
Print ISSN: 0048-5829
Electronic ISSN: 1573-7101
DOI: https://doi.org/10.1007/s11127-018-0605-6

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