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New approach needed for the formulation of fiscal policy rules

Author(s): Portes, J External Author(s): Simon Wren-Lewis Published: 20th May 2014

A new approach to the formulation of fiscal policy rules is needed, according to a new NIESR Discussion Paper written by Jonathan Portes (Director, NIESR) and Simon Wren-Lewis (Professor of Economics, University of Oxford).

Theory suggests that government should, as far as possible, smooth taxes and its recurrent consumption spending, which means that government debt should act as a shock absorber, and any planned adjustments in debt should be gradual. This suggests that operational targets for governments should involve deficits rather than debt, because such rules will be more robust to shocks.

Beyond that, fiscal rules need to reflect the constraints on monetary policy, and the extent to which governments are subject to deficit bias. Fiscal rules for countries in a monetary union or fixed exchange rate regime need to include a strong countercyclical element. They should also contain a ‘knock out’ if interest rates hit the zero lower bound - in which case the fiscal and monetary authorities should cooperate to formulate a fiscal expansion package that allows interest rates to rise above this bound.

Experience over the last few decades suggests that, in contrast to many other countries, there has not been sustained deficit bias in the UK; indeed, the main mistake made by the current government was to tighten fiscal policy too quickly, unnecessarily prolonging stagnation. However past UK governments were not perfect: history also suggests that governments, like the last one, are tempted to circumvent either the spirit or the letter of their own rules, and are too quick to cut public investment.

The design of fiscal policy rules is likely to depend on the extent to which governments are subject to deficit bias, and the effectiveness of any national fiscal council. For example, governments that had not shown a history of deficit bias, as with the UK, could aim for rolling deficit target; in contrast, governments that were more prone to bias could target a cyclically adjusted deficit at the end of their expected period of office. In both cases fiscal councils would have an important role to play, in ensuring plans were implemented in the first case and allowing for departures from target when external shocks occurred in the second.    

This suggests an appropriate framework for the UK, once interest rates start to rise, would be to keep the five year rolling target, but with three specific modifications:

  • First, the rule should explicitly apply to an environment where interest rates are above their lower bound.
  • Second, as monetary policy in this case should stabilise the economy five years out, there is no need to have a cyclically adjusted target. (This is a good reason for keeping the five year horizon, rather than shortening it to say three years. A three year target would also reduce the ability of deficits to absorb shocks.)
  • Third, the target should be for all new borrowing and not just the current balance; but to deal with the UK's historic tendency to short-termism, there should also be a specific target for the ratio of public investment to GDP.

Finally, numerical targets alone are not enough.  No matter how good the rules are in theory, it is always possible, at the margin, to move things on or off the balance sheet.  So at the same time, to avoid the inevitable temptation and tendency to manipulate the numbers, the Office of Budget Responsibility should be given a much wider remit.  It should look not just at the numbers and the fiscal aggregates, but what's going on behind the headlines, and it should have to give a view on whether the government is observing not just the letter but the spirit of the target, and not just over the specific time horizon but over the longer term.  

This combination of rules is based in economic theory, but flexible enough to cover a wide range of economic circumstances, with independent expert judgement to minimise - if not eliminate - the temptation for governments to manipulate the rules would be the best way forward for the UK. 

ENDS

Notes for editors:
For full copies of the report, please contact the NIESR Press Office:
Brooke Hollingshead on 0207 654 1923 / b.hollingshead@niesr.ac.uk

To discuss the research for interviews, please contact:

Jonathan Portes on 0207 654 1923 / j.portes@niesr.ac.uk / 07766441148

The discussion paper will published on the NIESR website on Wednesday 22 May here. It will also be published as a discussion paper on the Oxford University Department of Economics’ website here.

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