Unveiling the Truth: How Sticking to Fiscal Rules Boosts Investment in Latin America

There is a widespread belief that fiscal rules hinder public investment. The reasoning is straightforward: to adhere to these rules, governments often must reduce spending, particularly on infrastructure projects, which are not deemed essential in the short term.

But is that really the case? New evidence from Europe, emerging markets and Latin America shows otherwise. Governments that comply with fiscal rules end up enabling more investment. This discovery holds significant implications for Latin America and the Caribbean (LAC), where many countries often disregard fiscal rules during economic downturns or stress.

Rather than viewing fiscal rules as rigid constraints, the region should see them as valuable tools to promote both macroeconomic stability and sustained investment. This change in perspective is especially crucial now, as many LAC countries are undergoing fiscal consolidation to balance their budgets and reduce debt levels while facing increasing pressure from their populations to tackle key development challenges.

This blog explores the latest evidence and key policy insights, emphasizing the connection between compliance and investment. We will also discuss how governments can enhance their fiscal rules and adherence, transforming these instruments into valuable allies for fostering growth.

How Compliance Leads to Greater Investment: What the Research Shows

Empirical evidence suggests that by adhering to fiscal rules, governments are better positioned to sustain public investment over time, according to a 2024 study by Larch and van der Wielen on European fiscal rule compliance. Sticking to fiscal rules signals credibility, lowering borrowing costs and enabling smoother fiscal adjustments. This makes public investment more feasible for governments and more appealing to private investors.

A 2024 study by Ardanaz, Ulloa-Suárez, and Valencia also reinforces this view for emerging markets. They show that compliance with fiscal rules is associated with lower debt risk and greater credit stability. Conversely, non-compliance leads to higher borrowing costs threatening investment expenditure, especially during crises.

This underscores the idea that compliance—not merely the existence of fiscal rules—is the key driver of fiscal sustainability and investment capacity. Countries with fiscal rules, but weak compliance records face similar fiscal risks as those without rules at all.

Evidence from Latin America: Compliance Boosts Public Investment

In Latin America, compliance with fiscal rules is also linked to higher levels of public investment. Over the past two decades, countries with above-average compliance (68%) invested an average of 3.4% of GDP in public infrastructure, while those with lower compliance invested 2.7% of GDP—a 0.7 percentage point difference (Figure 1, Panel A).

As shown in Figure 1, Panel B, compliance benefits become even more substantial over time: two years after compliance, public investment tends to increase by up to about 0.3 percentage points of GDP. This suggests that while fiscal rules do not dictate investment levels, compliance creates the fiscal space necessary to sustain or expand public investment.

Figure 1. Public Investment and Fiscal Rule Compliance in Latin America

Latin America Needs to Improve Compliance with Fiscal Rules

Recognizing the crucial role of compliance, the Fiscal Management Division of the IDB has started tracking the adherence of LAC countries to their fiscal rules through the Compliance Hub within its FISLAC Platform. This fiscal intelligence tool, developed by the Bank, aims to support strategic fiscal policymaking in the region.

Compliance in the region tends to be highly procyclical. Between 2000 and 2023, average compliance stood at 68%, but history shows that during crises fiscal rules were often set aside when fiscal space became tight, according to a 2024 study by Valencia and Ulloa-Suárez.

As shown in Figure 2, in 2022, compliance spiked due to unexpected economic conditions and the design of expenditure rules, only to drop sharply in 2023. By 2024, even countries with strong track records struggled to meet their targets, and some increasingly relied on one-off transactions to justify compliance.

Figure 2. Evolution of Fiscal Rules in Place

This procyclicality exposes a significant weakness: current fiscal rules do not always hold up during economic distress. If compliance is dictated by economic cycles rather than institutional commitment, merely adopting fiscal rules is insufficient. To ensure compliance mechanisms withstand turbulence, it is essential to rethink the structure of fiscal rules, making them more adaptable while maintaining credibility. Enhancing their design will be a key factor whether they will support or hinder investment and growth, especially in emerging markets.

Three Strategies for Crafting Fiscal Rules that Promote Growth

Well-designed fiscal rules should provide a framework that balances fiscal sustainability with investment needs. Growth-friendly fiscal rules mitigate the risk of procyclical cuts, reduce economic volatility, and enhance long-term resilience by allowing investment to act as a stabilizing force.

According to a 2021 study by Ardanaz, Cavallo, Izquierdo, and Puig, there are three critical actions that can help fiscal rules support investment and growth:

• Focus your fiscal targets on structural balances to reduce investment procyclicality. Fiscal rules based on structural balances allow automatic stabilizers to function, preventing short-term budget fluctuations from disrupting long-term investment plans.
• Calibrate escape clauses to accommodate economic shocks. Clearly defined escape clauses allow governments to respond flexibly to crises without undermining fiscal credibility. These mechanisms should be carefully designed to prevent misuse while ensuring investment can be sustained when it is most needed.
• Remember that credibility and enforcement are as crucial as rule design. Even the most well-designed fiscal rules will fail if they lack credibility or are not consistently enforced. Many fiscal frameworks already include mechanisms to balance sustainability and investment needs, but their impact ultimately depends on the discipline with which they are enforced.

Enhancing Investment: Moving Beyond Fiscal Rule Compliance

It is important to recognize that compliance alone does not fully shield investment from competing spending pressures.

Social expenditures, debt service, and rigid budget commitments can still limit how much additional fiscal space translates into productive investment. While adherence to fiscal rules creates the conditions for sustainable public investment, broader fiscal policy choices determine how that space is used. For example, rising social expenditures – even though important – can progressively crowded out public investment, as shown by Larch and van der Wielen’s research. As a result, spending efficiency plays a key role in easing this dominance, as shown in Figure 3 below.

Figure 3. The Role of Investment Efficiency in the Impact of Fiscal Rule Compliance

To sum up, if countries want to move beyond fiscal compliance to enable more investment, they should consider the following lessons:

1. Spending efficiency is just as important as compliance. While fiscal rule compliance creates fiscal space, its real impact depends on how efficiently that space is used. Figure 3 illustrates this stark contrast: fiscal space expands over time in countries with high investment efficiency (75th percentile, right panel). In contrast, low-efficiency countries (25th percentile, left panel) see only a short-lived boost before fiscal space deteriorates. High-efficiency investments generate stronger economic returns, preventing fiscal space from eroding. Ardanaz, Llempén, Puig, and Valencia (2024) identified that governments that invest efficiently can triple the economic output of public investment.
2. Compliance is an asset that strengthens both public and private investment. Fiscal rule adherence signals credibility, lowering borrowing costs and enabling smoother fiscal adjustments. This makes public investment more feasible for governments and more attractive to private investors. Research shows that every dollar of public investment attracts $1.6 in private investment (Francois, Konte, and Ruch, 2024). Complementarity of private and public investment is key to boost economic growth and ease fiscal consolidation.
3. Strong institutions make fiscal rules effective. Compliance requires robust institutions that ensure credibility and long-term fiscal sustainability. Independent fiscal councils, transparent monitoring, and sound public financial management systems help sustain compliance and improve investment planning. Without these, governments risk repeated budget deviations, forcing last-minute adjustments that disrupt public investment, which may encourage perverse incentives like creative accounting or arbitrary exclusions that undermine the effectiveness of fiscal rules.

Main Takeaway

Compliance with fiscal rules is most effective when paired with efficient public spending and strong institutions. While the design of the rules matters, it is sustained compliance—particularly through countercyclical frameworks—that safeguards investment during economic downturns.

Strengthening public financial management and oversight mechanisms ensures that compliance leads to better fiscal outcomes, enabling LAC governments to preserve sustainability while unlocking investment for long-term development. Ultimately, viewing fiscal rules as allies for growth offers significant benefits to countries.

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