The views expressed in this presentation are the views of the author and do not necessarily reflect the

views or policies of the Asian Development Bank Institute (ADBI), the Asian Development
Bank (ADB), its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any
consequences of their use. Terminology used may not necessarily be consistent with ADB official terms.

Fiscal rules and fiscal space

Hamza Ali Malik

Director, Macroeconomic Policy and Financing for Development Division, UN-ESCAP

ADBI-ESCAP seminar on Fiscal Governance for Sustainable Growth and Development,

24 April 2019, Bangkok
Outline

• Defining fiscal rules and their objectives

• Rationale for fiscal rules -- some theoretical considerations

• Types and examples of fiscal rules

• Potential benefits and costs and practical challenges

• Towards an SDG-consistent fiscal responsibility framework

 Fiscal rules – definition and objectives
A fiscal rule imposes a long-lasting constraint on fiscal policy through numerical or non-
numerical limits on budgetary aggregates, with an aim to containing pressures to overspend
(deficit bias), particularly in good times (pro-cyclicality bias) … to ensure fiscal responsibility, and
thus macroeconomic stability and debt sustainability.
Two general classes of fiscal rules.
• legislated quantitative constraints on fiscal policy (much of the discussion on fiscal rules usually concerns such
restrictions);
• restrictions or rules on the procedure by which fiscal decisions are made
• all three stages of the budget process are considered -- formulation, approval, and implementation
• effective implementation also requires: monitoring and enforcement schemes (e.g., corrective mechanisms, sanctions, role
of a fiscal board/council); type of legislative support (e.g., coalition agreement, fiscal law); and quality of public financial
management systems (e.g., data reliability, budget reporting and audit, forecasting capacity).
Rationale for fiscal rules– some theoretical considerations

Most theoretical models assume that public debt is on a sustainable path and that
the intertemporal budget constraint is met. In practice this is not the case.

• Debt Sustainability Analysis

• persistently high level of public debt can adversely affect economic welfare, for instance
through adverse self-fulfilling expectations regarding governments (in)ability to service debt.

• Economic stabilization models (DSGE)

• determine optimal level of fiscal aggregates/stabilization policies that improve welfare by
reducing macroeconomic volatility.
Rationale for fiscal rules– some theoretical considerations
• Political economy models – budgets are not chosen by welfare-maximizing policymakers, but
are the result of a political process of budgeting.
o time-inconsistency issue -- incentives to deviate from previous promises when people and markets
have already adjusted their expectations and behavior;
o electoral motives to increase spending and reduce taxes in an election year;
o coordination issues among line ministries/different levels of government/coalition partners – common
pool problem
o population’s imperfect understanding of tax and debt finance, combined with a misperception of the
government’s intertemporal budget constraint -- fiscal illusion .
o bureaucratic behavior, which tends to focus on budget maximization;
o conflict of interest over who should pay for reducing the deficit, making deficit reduction a long-
delayed process -- free rider problem
o use of countercyclical fiscal policy --- expenditures are raised in a recession but not sufficiently lowered
in an expansion to balance the budget over the cycle
o each generation is selfish and does not care about thesituation for future generation – inter-
generational concerns
Types and examples of fiscal rules
• expenditure limits
• on total, primary or current spending
• in absolute terms or % of GDP
• nominal versus real

• revenue floors (or ceilings on government proceeds);

• Limits on overall balance

• Cyclically adjusted (what the fiscal balance would be if the output gap were closed)
• Adjusting for structural aspects (adjusting revenues and spending for one-off fiscal measures and/or
commodity price gains/losses)
• Golden rule (ceiling on overall deficit net of capital expenditures -- borrowing is permitted to finance
investment only; current spending must be covered by revenues).

• Limits on public debt

Most countries use a combination of such rules.

Fiscal rules – examples from Asia-Pacific
Expenditure Revenue Budget balance Debt
Armenia
Australia
Hong Kong, China
India
Indonesia
Iran, Islamic Rep.
Japan
Malaysia
Maldives
Mongolia
New Zealand
Pakistan
Russian Federation
Singapore
Sri Lanka Source: IMF Fiscal Rules Dataset
Fiscal rules – potential benefits
• Key Question: Do fiscal rules have the effect of slowing the growth of deficits or
stemming the accumulation of debt?

• No universal effect of rules on fiscal deficits

• Though rules have a positive average effect on the fiscal balance, more rigorous estimations
considering country characteristics often fail to identify systematic differences in the fiscal
behavior of countries with and without fiscal rules (Heinemann, Moessinger and Yeter, 2017)

• Design of the rules matters

• Using summary indices (comprising features like institutional coverage, independence of

monitoring/enforcement bodies, and statutory base), IMF (2018) finds that a rise in the index
from the 1st to 3rd quartile of distribution leads to average improvement of 0.6 pp of GDP in
fiscal balance.
Fiscal rules – potential costs
• potentially procyclical, encouraging fiscal retrenchment in bad times without
preventing fiscal relaxation in good times

• can allow the deficit bias to morph into a composition bias, wherein policy
makers reallocate spending away from high-quality items with longer-term
benefits

• if adopted without sufficient political buy-in or a solid public financial

management system, rules can also reduce transparency by encouraging creative
accounting or off-budget operations
 Fiscal rules – practical challenges

• Specific characteristics of developing countries

• (1) a volatile macroeconomic environment and less predictable business cycles (2) difficulties to
stabilize public expenditure; and (3) large development needs

• a proper calibration of the rule’s threshold is essential in all countries,

• no mechanical or universally accepted thresholds (Pescatori, Sandri and Simon, 2014)

• rules are hard to get right and have been repeatedly adjusted to the point of
becoming overly complex

• despite intense efforts to make rules more resilient, compliance has been
frustratingly low
Towards SDG-consistent fiscal responsibility framework
• Determine the long-term size of general government and key thresholds ,
keeping in view the SDG investment needs
• Develop consensus for fiscal rule(s) that allow government borrowing for
meeting the fiscal-related requirements of SDGs; will require a revisit of DSA.
• Implement a functional medium-term fiscal framework that is fully integrated
with the country's development/SDG priorities
• Decide annual targets for appropriate fiscal rules
• Decide the allocation of fiscal deficit space between central and subnational
government
• Specify exit clauses; address known volatilities (e.g. agriculture shocks, oil price)
Adapted from Rathin Roy (2016)
Fiscal rules and fiscal space

• How to balance meeting the investment requirements of SDGs (which needs

fiscal space) and debt sustainability?
• Do rules prevent the desirable use of fiscal space?
• How much fiscal space do countries have?
• How to incorporate potential dynamic effects of a fiscal
expansion/investments in support of SDGs?
• Importance of access to stable and affordable financing
Estimating investment needs
18
Additional investment needed to achieve
16
Sustainable Development Goals
14 (Percentage of GDP)
12
10
8
6
4
2
0
Least developed South and South- South-East Asia East and North-East North and Central
countries West Asia Asia Asia
Source: Economic and Social Survey of
People Prosperity Planet Asia and the Pacific, 2019
 Percentage of GDP

0
10
20
30
40
50
60
80
70
Uzbekistan

Russian Federation

Kazakhstan 2017
Nepal

Turkey
2022

Indonesia

Iran (Islamic Republic of)

Bangladesh

Philippines

Papua New Guinea

Myanmar

Cambodia
stable, at about 42 percent of GDP on average

Republic of Korea
Understanding fiscal space

Thailand

Azerbaijan

China

Tajikistan

Malaysia

Kyrgyzstan

Viet Nam

Lao PDR

Pakistan

India

Sri Lanka
For developing Asia-Pacific region, IMF projections suggest near-term debt outlook is

Source: Economic and Social Survey of Asia and the Pacific, 2018
 Understanding fiscal space
Even under an adverse shock, only about half of the countries in the region would
face an upward pressure on debt levels
Baseline scenario Scenario with less favourable differential
between interest rate and GDP growth
6
Debt-stabilizing primary balance (percent

Debt-stabilizing primary balance under a 1

standard deviation shock (percent of GDP)
4
debt- debt-
4
increasing increasing
2
2

0
0

-2
-2
of GDP)

-4
-4

-6
-6

-8
debt- -8 debt-
-10 decreasing decreasing
-10

-12 -12
-12 -10 -8 -6 -4 -2 0 2 4 6 -12 -10 -8 -6 -4 -2 0 2 4 6
Primary balance in 2016 (percent of GDP) Primary balance in 2016 (percent of GDP)

Source: Economic and Social Survey of Asia and the Pacific: Year-end Update 2017
Understanding fiscal space
Countries’ ability to mobilize domestic resources seem to have strengthened in recent
years, which bodes well for the fiscal space
35

Tax revenue 2012 vs. 2017

Tax revenue in 2017 or latest in % of GDP

30 New Zealand
Australia Macao, China
Solomon Islands
Samoa Fiji
25 Georgia
Maldives Republic of Korea
Armenia Kiribati
Nepal Tonga Uzbekistan
Viet Nam
20
Tajikistan Kyrgyzstan
Japan China Russian Federation
Vanuatu Turkey
Marshall Islands
Cambodia Singapore Thailand Mongolia
15 Philippines Kazakhstan
Azerbaijan Papua New Guinea
Sri Lanka Hong Kong, China Malaysia
Micronesia Bhutan Timor-Leste
India Lao PDR
10 Pakistan Indonesia
Bangladesh
Afghanistan
5 Myanmar

0
0 5 10 15 20 25 30
Tax revenue in 2012 in % of GDP

Source: Financing for Development in Asia and the Pacific: Highlights

in the Context of Addis Ababa Action Agenda, 2019
 Understanding fiscal space
Many developing countries in Asia-Pacific lack access to stable and affordable
financing (Record of public bond issuance, 1996-2016)
No bond issuance Domestic bonds only Both domestic and foreign bonds
Afghanistan Bangladesh Armenia
Bhutan Fiji Azerbaijan
Brunei Darussalam Hong Kong, China China
Cambodia India Georgia
Democratic People's Republic of Korea Kyrgyzstan Indonesia
Iran (Islamic Republic of) Lao People’s Democratic Republic Kazakhstan
Kiribati Myanmar Malaysia
Macau, China Nepal Mongolia
Maldives Singapore Pakistan
Marshall Islands Uzbekistan Philippines
Micronesia (Federated States of)
Palau Vanuatu Republic of Korea
Papua New Guinea Russian Federation
Samoa Sri Lanka
Solomon Islands Thailand
Tajikistan Turkey
Timor-Leste Viet Nam
Tonga
Turkmenistan
Source: Economic and Social Survey of Asia and the Pacific, 2018
Tuvalu
 Understanding fiscal space
Many developing countries lack access to stable and affordable financing
With few exceptions, countries with large However, they have few borrowing options in
investment needs have manageable debt levels domestic or international financial markets

Source: Economic and Social Survey of

Asia and the Pacific, 2019