Frequently Asked Questions

Why is there increasing interest in Fiscal Councils

Although some Fiscal Councils have been in existence for many years (for example, the CPB in the Netherlands), in the last few years new Fiscal Councils have been created (e.g. Sweden, Hungary and the UK). There are proposals for new Councils in Ireland, Portugal and Slovakia. There has also been an increase in the number of academics putting forward the case for some form of Fiscal Council (see papers here). In part this reflects the failure of fiscal rules to bring an end to deficit bias.

Fiscal Councils and Fiscal Rules

The initial reaction to the problem of deficit bias, both in government and academia, was to explore the use of fiscal rules that might provide a constraint on governments. Probably the most notable example is the Stability and Growth Pact of the Eurozone. However these rules have not been very successful, in the sense that they have not been adhered to. One of the problems with fiscal rules is that simple rules are clearly suboptimal, but more complex rules are difficult to monitor. (The most straightforward example is the need to let the automatic stabilisers operate, but the difficulty in calculating cyclically adjusted deficits.)

A Fiscal Council could be seen as an alternative to a fiscal rule, reflecting the difficulty in formulating a simple optimal rule. (See Kirsanova, Leith and Wren-Lewis (2007), for example. Monetary policy is increasingly operated by independent institutions that do not follow an explicit rule.) However in practice Fiscal Councils often operate within the context of existing fiscal rules, and are seen in part as watchdogs that ensure that these rules are adhered to. (Occasionally they may sanction deviations from them – see below). The relationship between fiscal rules and Fiscal Councils is discussed in Calmfors and Wren-Lewis (2011).

Why Is Deficit Bias a Problem?

• • If government debt gets very large, a risk premium reflecting the possibility of default may emerge.

  • A large negative shock may weaken the power of monetary policy when a zero lower bound for interest rates is hit. In this situation governments should want the ability to expand fiscal policy to support demand, without fear that higher debt will create concerns over default.

  • If the current generation does not act in a way that looks after future generations, then there is a danger that capital accumulation will be sub-optimal. In these circumstances, higher debt crowds out private capital. (In contrast, if the conditions for Ricardian Equivalence hold, then government debt just represents deferred taxes, and has no effect.) Now if the existing stock of capital is not sub-optimally high (which is possible but unlikely), then higher debt reduces capital further away from its optimal level, which in turn reduces long term output and welfare. In addition, the current generation may simply exploit future generations, leading to an unfair distribution between generations.

Why might Fiscal Councils reduce deficit bias?

• • By making fiscal positions more transparent, they may prevent governments deliberately concealing the extent of future deficits implied by current policies, or prevent governments being overoptimistic about their finances. The public may have insufficient information to differentiate between governments that are more efficient at managing spending, and those that pretend to be in order to win votes through spending increases or tax breaks. A Fiscal council could help provide that information.

  • Because governments in a democracy may not be re-elected, there may be an incentive for them to discount the future heavily. In particular, by raising debt, they may stifle the spending plans of the opposition. If political parties differed over the size of the state, and if raising spending or cutting taxes was easier than the opposite, then raising debt might be the most effective way of achieving political aims.

  • In the previous cases, if the public had full information and could discipline governments, deficit bias would not arise. An alternative reason for deficit bias is that the public may be selfish, in the sense that they attempt to exploit future generations, or they may be unable to resist immediate temptations. A Fiscal Council could attempt to apply political pressure on behalf of future generations, or provide moral pressure to discount the future less heavily. They may also prevent politicians pandering to these tendencies.

  • Fiscal Councils may reduce the ‘common pool problem’ (see below). They can provide a coordination device that forces individual spending ministers to recognise the overall budget constraint: to ‘internalise the common pool externality’.

Forecasting

One of the motives for setting up a Fiscal Council may be a concern that governments are inclined to make overoptimistic projections of the public accounts (see Jonung and Larch (2006) for example). However not all Fiscal Councils prepare their own forecasts (e.g. Sweden). Equally, presentation of an independent projection for public deficits and debt is not a guarantee that governments will observe fiscal discipline. (The example of the United States under George W. Bush perhaps.) Variation here may reflect different institutional contexts in which fiscal projections are made: for example, are the macroeconomic forecasts used by a government produced by institutions with a reputation to protect, or are they the property of the government itself.

Fiscal Demand Management

There is a potential tension between using fiscal policy as a tool of demand management, and avoiding deficit bias. It may be politically convenient to expand fiscal policy in a downturn, but ignore the possibility of contraction in a boom. In an economy operating within a floating exchange rate regime, the question arises whether monetary policy should be entirely responsible for demand management (see Kirsanova, Leith and Wren-Lewis, 2009). Even in this case, however, if interest rates hit a zero lower bound, there is general agreement that fiscal expansion can and should play a role in supporting output. For countries operating under fixed exchange rates, or in a monetary union, there may be a more general case for using discretionary countercyclical fiscal policy.

In this context, a Fiscal Council may have an important role in ensuring that any demand stabilisation role for fiscal policy does not take place at the expense of a longer term prudent debt policy. The existence of a Fiscal Council could in this context make discretionary countercyclical policy easier for governments to undertake. In 2009 the Swedish Fiscal Council suggested additional fiscal expansion beyond that proposed by the government. A Fiscal Council could help overcome time inconsistency issues involved in countercyclical policy that are familiar from the monetary policy literature.

What is the Common Pool Problem?

Because spending measures tend to targeted at specific groups, but financed (sooner or later) through general taxation, then the voice of the beneficiaries favouring spending increases may be more effective than the more muted voice of the much larger group who lose (a little). (Much the same would be true of specific tax breaks, financed through general increases in taxation.) If general tax increases to finance spending increases or specific tax breaks are postponed, then deficit bias results. This problem may be particularly acute where there is a lack of coordination between spending ministries in government, or where the finance minister does not have much power. In this context, a Fiscal Council can play a coordinating role, and enhance the position of the finance minister.