Inter-American Development Bank
facebook
twitter
youtube
linkedin
instagram
Abierto al públicoBeyond BordersCaribbean Development TrendsCiudades SosteniblesEnergía para el FuturoEnfoque EducaciónFactor TrabajoGente SaludableGestión fiscalGobernarteIdeas MatterIdeas que CuentanIdeaçãoImpactoIndustrias CreativasLa Maleta AbiertaMoviliblogMás Allá de las FronterasNegocios SosteniblesPrimeros PasosPuntos sobre la iSeguridad CiudadanaSostenibilidadVolvamos a la fuente¿Y si hablamos de igualdad?Home
Citizen Security and Justice Creative Industries Development Effectiveness Early Childhood Development Education Energy Envirnment. Climate Change and Safeguards Fiscal policy and management Gender and Diversity Health Labor and pensions Open Knowledge Public management Science, Technology and Innovation  Trade and Regional Integration Urban Development and Housing Water and Sanitation
  • Skip to main content
  • Skip to secondary menu
  • Skip to primary sidebar
  • Skip to footer

Ideas Matter

  • HOME
  • CATEGORIES
    • Behavioral Economics
    • Environment and Climate Change
    • Macroeconomics and Finance
    • Microeconomics and Competitiveness
    • Politics and Institutions
    • Social Issues
  • Authors
  • Spanish

Fiscal Rules for Commodity-Dependent Economies

November 27, 2023 by Rodrigo Heresi Gajardo Leave a Comment


In recent decades, numerous governments in Latin America and the Caribbean have adopted fiscal rules, which try to enforce fiscal discipline on governments and stop them from pro-cyclical spending, which involves spending too much when times are good and taking the ax to spending when times are bad. Pro-cyclical policies have been a historical trend in the region. They have not only generated wild swings, or volatility, in spending, but left countries without the financial resources to counteract economic downturns, including those caused by foreign shocks, such as a withdrawal of foreign investment or low commodity prices.

Cyclically-adjusted fiscal rules, or rules that take into account long-term economic trends, were designed precisely to prevent such pro-cyclical behavior by governments and curb the spending temptations that come with the need to please voters and win elections. But not all fiscal rules are the same. There are acyclical spending rules that require the government to pay back debt (or accumulate assets) when revenues are higher than usual and accumulate debt and spend assets when revenues are lower than the trend. And there are countercyclical fiscal rules that seek to further lean against the wind of economic cycles, increasing spending in bad times more aggressively than under a purely acyclical policy rule. 

Determining the Level of Fiscal Activism

The key is finding the optimal degree of fiscal activism. Should governments seek to just insulate spending from volatile fiscal revenues through an acyclical rule, or is there a macroeconomic role in stabilizing the cycle via a countercyclical rule? Is the optimal response to the cycle of tax revenues the same as the optimal response to commodity-related revenues? And what is the role of social transfers and public investment?

To answer these questions, I set up a quantitative model of a small and open commodity-dependent economy in which a significant fraction of output and public revenues depends on exogenous, or external, volatile commodity prices. The economy features two household types: “savers” and “non-savers”. Savers own shares in the economy’s productive firms and have access to credit from the financial market which gives them money to spend even when the economy is in the doldrums. Non-savers, by contrast, live “hand-to-mouth” or are “financially constrained.” They work for a wage, consume their labor income period to period, and do not have access to credit markets. 

Government revenues came from taxes and owning a share of the country’s commodity wealth. Government proceeds are spent on consuming goods and services, investing in (productive) public infrastructure, and targeted social transfers. The government follows a fiscal expenditure rule characterized by two policy parameters determining whether the government reacts procyclically, acyclically, or countercyclically to fluctuations in (1) tax revenues and (2) commodity-related revenues. 

The results show that the welfare of non-savers, or those who are most vulnerable, is maximized under a strongly countercyclical stance with regard to tax revenues. A  moderately procyclical approach to commodity revenues is also beneficial to them. In contrast, any deviation from the acyclical benchmark makes savers worse off.

Procyclical fiscal spending amplifies economic cycles and unambiguously harms all households. A countercyclical response to the tax revenue cycle, however, has a powerful macroeconomic stabilization effect. For instance, a procyclical balanced-budget rule regarding tax revenues increases the volatility of real GDP growth by 19% relative to an acyclical benchmark, implying a considerable welfare loss of 2.6% in lifetime spending for non-savers. In contrast, the countercyclical rule that maximizes non-savers welfare enables a 12% reduction in the volatility of GDP growth, leading to a welfare gain of 0.6%.

Handling Different Revenue Streams    

Notably, there can be too much fiscal activism regarding commodity-related revenues.  Since tax revenues are a direct function of domestic economic activity, household income and tax revenue are higher than usual when the economy is booming. So intuitively, a countercyclical response to tax revenues is desirable as it stabilizes aggregate output and household income. In contrast, commodity revenues are mainly a function of persistent fluctuations in international commodity prices, which do not (necessarily) correlate with the domestic business cycle. For instance, if commodity prices rise considerably during a domestic economic recession, a countercyclical response to the commodity windfall would cut spending. This would drag the economy further down, amplifying economic cycles and preventing the country from using the added revenues as a boost.

According to our quantitative results, the larger the share of financially constrained people and the lower the incidence of commodity revenues in total budgetary revenues, the more likely the optimal fiscal policy would be countercyclical. Each spending component plays a key role: government spending and especially public investment help stabilize real GDP, while social transfers are essential to allowing financially constrained households get through bad times.

If cyclically adjusted fiscal rules deliver macroeconomic stability and welfare gains, why are they not more widely used across Latin American countries? On the one hand, they  are challenging to implement and sustain credibly over time, as they require substantial fiscal responsibility that outlive a particular government. Poor institutional quality often leads to discretionary spending by short-sighted governments, while limited access to international credit markets may prevent them from taking on additional debt, especially in bad times. On the other hand, countercyclical rules, while stabilizing for the economy as a whole, may involve more volatility, or swings, in government spending and debt.

Policymakers in the region could benefit from the Chilean experience. In 2006, Chile passed a law mandating an acyclical fiscal rule that was already being implemented.   The results from our study suggest that additional welfare gains would be possible by moving from that neutral acyclical policy to an actively countercyclical approach.

The Need for Flexibility in the Design of Fiscal Rules

Of course, the specific design of fiscal rules will depend on context: no single approach is appropriate for every country. For instance, if a developing country has accumulated net foreign assets during a prolonged period of economic prosperity and needs financing for development projects, it may be in everybody’s interest to spend more than an otherwise rigid fiscal rule would allow. Such escape clauses require political and technical consensus about the economy’s absorptive capacity and independent oversight to function correctly. On the other hand, in the face of a large and persistent commodity price boom, the government may also wish to build a prudent buffer fund — such as Chile’s Economic Stabilization Fund — to protect against the possibility of future economic disasters. Such funds can also cover contingent (potential) liabilities, like those related to future pensions, or aim for intergenerational equity.


Filed Under: Macroeconomics and Finance Tagged With: #FiscalRules

Rodrigo Heresi Gajardo

Rodrigo Heresi Gajardo es economista en el Departamente de Investigación del Banco Interamericano de Desarrollo.

Reader Interactions

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Primary Sidebar

Follow Us

Subscribe

Search

Related posts

  • Fiscal Rules for a Debt-Plagued Region
  • The Imperatives of Fiscal Health
  • Fiscal Fatigue in Latin America and the Caribbean: A Growing Threat
  • Fiscal Discipline: Can Constitutions Help?
  • Time to Adjust: But How, and When?

About this blog

The blog of the IDB's Research Department shares ideas that matter on public policy and development in Latin America and the Caribbean.

Footer

Banco Interamericano de Desarrollo
facebook
twitter
youtube
youtube
youtube

    Blog posts written by Bank employees:

    Copyright © Inter-American Development Bank ("IDB"). This work is licensed under a Creative Commons IGO 3.0 Attribution-NonCommercial-NoDerivatives. (CC-IGO 3.0 BY-NC-ND) license and may be reproduced with attribution to the IDB and for any non-commercial purpose. No derivative work is allowed. Any dispute related to the use of the works of the IDB that cannot be settled amicably shall be submitted to arbitration pursuant to the UNCITRAL rules. The use of the IDB's name for any purpose other than for attribution, and the use of IDB's logo shall be subject to a separate written license agreement between the IDB and the user and is not authorized as part of this CC- IGO license. Note that link provided above includes additional terms and conditions of the license.


    For blogs written by external parties:

    For questions concerning copyright for authors that are not IADB employees please complete the contact form for this blog.

    The opinions expressed in this blog are those of the authors and do not necessarily reflect the views of the IDB, its Board of Directors, or the countries they represent.

    Attribution: in addition to giving attribution to the respective author and copyright owner, as appropriate, we would appreciate if you could include a link that remits back the IDB Blogs website.



    Privacy Policy

    Copyright © 2025 · Magazine Pro on Genesis Framework · WordPress · Log in

    Banco Interamericano de Desarrollo

    Aviso Legal

    Las opiniones expresadas en estos blogs son las de los autores y no necesariamente reflejan las opiniones del Banco Interamericano de Desarrollo, sus directivas, la Asamblea de Gobernadores o sus países miembros.

    facebook
    twitter
    youtube
    This site uses cookies to optimize functionality and give you the best possible experience. If you continue to navigate this website beyond this page, cookies will be placed on your browser.
    To learn more about cookies, click here
    X
    Manage consent

    Privacy Overview

    This website uses cookies to improve your experience while you navigate through the website. Out of these, the cookies that are categorized as necessary are stored on your browser as they are essential for the working of basic functionalities of the website. We also use third-party cookies that help us analyze and understand how you use this website. These cookies will be stored in your browser only with your consent. You also have the option to opt-out of these cookies. But opting out of some of these cookies may affect your browsing experience.
    Necessary
    Always Enabled
    Necessary cookies are absolutely essential for the website to function properly. This category only includes cookies that ensures basic functionalities and security features of the website. These cookies do not store any personal information.
    Non-necessary
    Any cookies that may not be particularly necessary for the website to function and is used specifically to collect user personal data via analytics, ads, other embedded contents are termed as non-necessary cookies. It is mandatory to procure user consent prior to running these cookies on your website.
    SAVE & ACCEPT