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Harvest today's windfalls for tomorrow's shortfalls

Favourable economic conditions over the past couple of years have provided Member States’ governments with a precious opportunity to improve the sustainability of their budgets. Whilst those with excessive deficits have done well to bring them down, too little has been done by most Member States to reduce deficits further. The opportunity of good economic conditions should enable all Member States to improve their budgetary frameworks for the longer term, but few are taking real advantage of this. The preventive arm of the Stability and Growth Pact – which has been overshadowed by the deterrent function embodied in the excessive deficit procedure – provides the tools to help Member States improve their budgetary situation for the future, so the Commission is recommending ways to make it more effective.

Euro banknotes forming a percentage sign © Emrah Turudu
© Emrah Turudu

“If Member States run sound public finances, as a rule, they will never find themselves in a position where they have to correct an excessive deficit,” underlined Joaquín Almunia, Commissioner for economic and financial affairs, presenting the 2007 ‘Public Finances in EMU’ report in June. “And that is why the preventive arm of the Stability and Growth Pact (SGP) is of crucial importance.”

Whilst he acknowledged the success of Member States in reducing excessive deficits – with all but two expected to bring their deficits below 3% of GDP before the end of 2008 – he expressed a number of worries about deviations from the sound fiscal policy principles of the revised SGP.

“In 2006, the better-than-expected budgetary outturn was primarily driven by important positive surprises in tax revenues. But part of these revenues were used to finance expenditure that had not been envisaged in the Stability and Convergence Programmes,” he noted. “And some Member States are also currently considering tax cuts. However, such measures carry the clear risk of being pro-cyclical and could lead to a worsening of the underlying position of government finances.

“Finally, the budgetary plans of Member States are disappointing. In 2007 and 2008, in spite of a favourable economic outlook, the planned structural adjustment of countries that are not yet at their medium-term budgetary objective (MTO) falls short of the 0.5% of GDP benchmark required by the preventive arm of the SGP,” he emphasised. “This means that under unchanged policies, only ten of the 27 EU countries will be at, or will have maintained, the medium-term objective for their public finances, by 2008.

“In the coming years, our main objective will be to ensure a better operation of the preventive arm of the SGP,” he concluded. “The aim is to take full advantage of the current economic good times to accelerate the convergence towards sustainable fiscal positions.” With that in mind, the Commission welcomes the commitment made, in April, by ministers in the Eurogroup to design 2008 fiscal policy plans “to accelerate adjustment towards the MTO for Member States which have not reached it, and for those which have reached it to avoid feeding macroeconomic imbalances overall”.

Medium-term budgetary objectives

First agreed by the Council in 1997, the Stability and Growth Pact (SGP) was revised in 2005, in the light of experiences since the introduction of the euro. A key desire for both the Commission and Council was to make the pact more effective in ensuring Member States’ budget deficits do not come close to, never mind exceed, the threshold at which the excessive deficit procedure is triggered (i.e. a deficit of 3% of GDP or more).

Whilst the original SGP set each Member State the requirement to keep its budget close to balance or in surplus, the revised pact recognises the need for individual Member States to have greater flexibility to suit their individual economic circumstances, and in particular to support public investment needs. Each Member State therefore sets its own medium-term budgetary objective (MTO). Effectively, this is the position it aims to reach within the period of its stability and convergence programme, which runs for four years and is revised annually. And the programme sets out the steps it will take over that period to reach the target.

For those Member States which have already adopted the euro and those which are members of the exchange rate mechanism (ERM II), the pact limits the MTO to a deficit of no more than 1% of GDP. Moreover, the pact requires those countries to make budgetary corrections each year of 0.5% of GDP in structural terms*, as a benchmark, towards their MTO. Countries outside the euro area or ERM II are not bound by these provisions, but are nonetheless expected to ensure rapid movement towards a sustainable budgetary position.

* Net of cyclical components and one-off measures

Learning lessons

“The pattern we have seen in the past couple of years is similar to that which we saw in 1998-2000: economic boom coupled with better than expected tax revenue. And that tax revenue has made a greater than normal contribution to GDP growth,” says Elena Flores-Gual, Director in the Commission’s Economic and Financial Affairs DG. “On the other hand, too many Member States have shown that they have significant difficulties in controlling expenditure.”

Figure 1: Frequency of at least 0.5% of GDP improvements of the cyclically-adjusted primary budget balance (CAPB) over consecutive years

Figure 1: Frequency of at least 0.5% of GDP improvements of the cyclically-adjusted primary budget balance (CAPB) over consecutive yearsSource: Commission services

Source: Commission services

The Commission’s concern is that many Member States are not taking the opportunity offered by the current economic upturn to put their budgets on to more sustainable foundations. In other words, the efforts they could and should be undertaking now to make the next bust less painful are simply insufficient. In some cases, the windfalls governments have received during the upturn are being spent, rather than used to reduce budget deficits, which would make it easier to accommodate future shortfalls.

It is understandable that governments prefer to focus on short-term benefits, but past economic crises have been deepened because governments have not taken opportunities to make their budgets more sustainable. Longer-term improvements to the fiscal position are essential to ensure sustainability throughout the economic cycle. To reduce the chances of excessive deficits in future downturns, the Commission is seeking ways to ensure Member States are more effective in meeting their medium-term objectives now.

Political commitment

“Member States’ budgetary plans often leave the ambitious measures until the final years,” Flores-Gual emphasises. “And when one year’s targets are not met, efforts in the following year are not stepped up, meaning the gap between the target and actual performance increases.”

A second problem is that annual government budgets, which are what people focus on, often do not add up to meet the medium-term budget plans. Whilst budgets are usually debated in parliament and given extensive media coverage, in many countries the multi-annual budget framework has much less publicity, and may not even be presented in parliament. If it remains a technical document, largely restricted to government use, parliamentarians and the public will not be able to hold government to account if medium-term objectives are not met.

Finding solutions

“In the past, we have seen significant differences in Member States’ abilities to meet their medium-term objectives. One factor common to many Member States has been that governments have had difficulties in controlling expenditure,” Flores-Gual notes. “In this report, we have analysed what factors have contributed to the success of fiscal consolidation in different countries, and looked at how Member States can stick to their targets better.”

The Commission has made proposals in four areas to strengthen the functioning of the preventive arm of the SGP (although it proposes no changes to the rules themselves). These proposals aim to enable all Member States to learn from the successes of others.

Broad economic perspective

First, fiscal policy has to be considered more in relation to the broader macroeconomic conditions in the country concerned (and in the euro area as a whole for its members). Factors, such as inflation, external trade balances and competitiveness, need to be understood and factored in when assessing national fiscal policy-making. Moreover, governments need to strive to use public funding more efficiently and effectively, so that demand for services does not lead to ever-increasing expenditure.

Figure 2: Composition of the variation in the budget position 2006-2009 (% of GDP)

Figure 2: Composition of the variation in the budget position 2006-2009 (% of GDP)Note: A positive value indicates a positive contribution to the change in budgetary position. A positive value in total variationof budgetary position (value is presented on top of columns) indicates an improvement in the balance.Source: Commission services, on the basis of the 2006/07 updates of the Stability and Convergence Programmes

Note: A positive value indicates a positive contribution to the change in budgetary position. A positive value in total variationof budgetary position (value is presented on top of columns) indicates an improvement in the balance.

Source: Commission services, on the basis of the 2006/07 updates of the Stability and Convergence Programmes

The Member States’ stability and convergence programmes should therefore place more emphasis on their planned changes to public expenditure and taxation, and the expected effects on the economy. They should also include reforms to budget-making and implementing institutions and procedures conducive to a more efficient use of public spending. Within the euro area, greater emphasis needs to be given to correcting structural imbalances, such as large external trade deficits or surpluses, or inflation, to enable sustainable convergence between Member States.

National ownership

Second, a major reason for poor performance up to now has been a lack of commitment to budgetary targets from the wealth of public bodies which spend across many Member States. Therefore, national parliaments have to be fully involved in setting the medium-term objectives, as do the different branches and levels of government. Involvement of this nature should enable public bodies to commit themselves to contributing to meeting the targets.

The Commission would also like to see governments going further, to incorporate the provisions of their stability and convergence programmes into national rules, thereby strengthening their political aspirations. In that respect, it has found that those Member States which have created rules-based multi-annual financial frameworks have been much better at sticking to budgetary objectives, in particular on the expenditure side.

Reliable and credible targets

Third, past instances of budgetary targets being missed risk diluting confidence in the medium-term objectives, particularly if governments continue to fall short. It is therefore essential, for credibility, to set targets which are achievable, so the growth forecasts, used as the basis for budgetary planning, need to be realistic.

The Commission is also recommending to Member States that they be much more explicit in their stability and convergence programmes, outlining the policy measures needed to meet the targets they have set themselves. Furthermore, the programmes should also set out, in parallel, projections for budgetary variables with no change in policy, showing the gap between the two and, by extension, the size of the task faced by that country.

Medium-term sustainability

Fourth, Member States’ governments face difficult choices over structural reforms and how to achieve fiscal consolidation. Both are essential, so budgetary programmes need to be drawn up realistically to ensure sustainability of public finances. Given past performance, better understanding of the reasons why targets were missed is needed for improving performance in the future.

The Commission intends, in the coming years, to put forward a revised framework for setting medium-term objectives which takes greater account of sustainability of public finances. This will be a valuable tool to achieve budgetary consolidation in the longer term, with revised medium-term objectives for each Member State established to ensure they are better equipped to tackle the challenge of ensuring sustainability in the face of demographic change.

In addition, when it assesses stability and convergence programmes, the Commission will focus more attention on past performance in meeting targets. In the Eurogroup, the Member States which have adopted the euro could go a step further, comparing annual budgets with their medium-term targets, and feeding into the mid-term review of fiscal policies. This review aims to foster coordination of fiscal policies amongst the member countries.

Peer pressure

Newton’s cradle with euro symbols instead of metal spheres © Erick Nguyen
© Erick Nguyen

The Stability and Growth Pact, in its preventive arm, has no sanctions for Member States which do not meet their objectives. Rather, the aim is to use peer pressure to encourage governments to stick to the path towards fiscal consolidation and more sustainable budgets. Whilst, overall, Member States’ performances have been disappointing, some have stood out. Indeed, some Member States have set themselves, and achieved, far more ambitious targets than the benchmarks set out in the SGP. The Commission’s task in the wake of this report is to encourage other Member States to follow their example and raise their own standards.

Further information

Further information

2007 Public Finances Report