With a long history of recurrent and costly debt crises, Latin American governments have long sought to find a way to curb the fiscal deficits that stoke the debt problem. Those efforts gathered steam over the course of the 2000s when numerous governments in the region began adopting fiscal rules, which seek to curb politicians’ ability to increase spending under political and electoral pressure and base fiscal policies instead on numerical indicators related to budget balances or macroeconomic performance.
But, as our research shows, the mere adoption of fiscal rules is insufficient to ensure fiscal health and sustainable debt-to-GDP ratios. By 2021, for example, 106 countries in the world had adopted fiscal rules, including around 15 in Latin America and the Caribbean. Examining our global sample for the period 2000-2019, however, we found that there was not much difference in average debt growth for countries during periods when they had a least one fiscal rule in place and periods when they had no fiscal rule at all. Problems designing rules-based fiscal frameworks and low compliance, among others, hindered effectiveness. Indeed, Latin American countries were compliant with the spending restrictions of their fiscal rules less than one third of the time.
Designing Fiscal Rules
The challenges of designing fiscal rules are complex. Early fiscal rules were criticized as being too oriented around the achievement of headline budget balances, which limited policymakers ability to spend in the face of economic shocks. Such rules also encouraged policymakers to engage in procyclical behavior; i.e., spending too much when the economy was doing well without concern for saving for potentially bad times in the future. But when Chile (2001) and Colombia (2011) implemented more sophisticated structural balance rules that instead tried to take into account output and commodity prices, those efforts also fell short in reducing debt growth despite strenuous efforts at compliance. In Colombia, for example, where the rules were oriented around potential GDP growth and the long-term price of oil, the nation’s principal export, predictions turned out to be far too optimistic, leading to fiscal policy that was more expansionary than it should have been and increasing debt levels.
None of this is to say that well-designed fiscal rules cannot make an important difference. Our study shows that average debt-to-GDP growth falls more than three percentage points per year with high quality fiscal rules, compared to low quality ones, and that debt volatility falls under strong quality rules to one third of the volatility under low quality ones.
Aiming for a Prudent Level of Debt and Better Expenditure Allocation
A key innovation in designing higher quality rules is to set a maximum level of acceptable debt and then calibrate a more “prudent” level, which can serve as a medium-term fiscal policy “anchor” or target. As Chile and Colombia have recently done, countries can then implement a feedback mechanism based on the outstanding amount of public debt, applying more adjustment pressure as outstanding debt levels exceed prudent ones. That allows them to ensure that debt does not grow to levels that undermine fiscal sustainability with an embedded self-regulating mechanism.
Proper fiscal rule design can also lead to better expenditure allocation, particularly when it comes to protecting expenditures that typically don’t have strong political support despite their proven economic benefits, like public investment. Flexible features in fiscal rules can safeguard vital public spending on capital investments, including growth stimulating infrastructure, and provide escape clauses to allow governments to temporarily suspend the rules in the midst of crises, like the COVID-19 pandemic. It has been shown that flexible rules that explicitly or implicitly protect public investment are more growth-friendly. However, once flexible arrangements like escape clauses are included, rules should provide guidance for a return to compliance in the aftermath of a negative shock so as not to lose credibility.
Complementary Fiscal Institutions
Political will and enforcement are essential for increasing fiscal rule effectiveness. Independent, non-partisan fiscal councils can play a critical role in this regard, verifying whether rules are being complied with, recommending ways to return to compliance when they are not, and inflicting reputational costs on governments that ignore them. They may even have a mandate to enforce a return rule to compliance after repeated periods of non-compliance.
All these issues have come to the fore since the pandemic as governments realized how necessary it was to fix the shortcomings of existing fiscal frameworks.
Evidence makes it abundantly clear that fiscal rules alone are not enough to stabilize debt-to-GDP ratios and ensure fiscal sustainability. But in a region where fiscal indiscipline and excessive debt have often been a curse; where the average public debt-to-GDP ratio is currently well above the average of preceding decades; and where globally rising interest rates will boost the cost of debt financing, they can make an immense contribution when well designed and enforced. Fiscal policies need to have a clear long-term objective. They need to have an explicit anchor that corresponds to debt levels, and complementary institutions, like fiscal councils, that bolster compliance with numerical rules. Reforms that move in that direction will help keep debt in check, adding to efforts to stoke greater growth, equity and sustainability in challenging times.