Macroeconomics

Fiscal rules during the Covid-19 pandemic

  • Blog Post Date 30 January, 2021
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Sahana Roy Chowdhury

International Management Institute Kolkata

sahana.isi@gmail.com

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Radhika Pandey

National Institute of Public Finance and Policy

radhika.pandey@nipfp.org.in

Several countries have amended their fiscal rules to provide for additional public spending, in order to revive their economies that have been adversely hit by the pandemic. In this post, Radhika Pandey and Sahana Roy Chowdhury examine the fiscal strategies to deal with the Covid-19 shock of a set of countries that belong to the G20 group or the middle-income EMEs, and are broadly similarly placed as India.

Countries across the globe have taken several fiscal policy measures to mitigate the negative impacts of the Covid-19 pandemic on livelihoods and on economies. As of 11 September 2020, the announced fiscal measures add up to an estimated be US$11.7 trillion or approximately 12% of global GDP (gross domestic product) (International Monetary Fund (IMF), 2020). Half of these fiscal measures include additional public spending in the form of stimulus packages and the like, and foregone revenues such as tax cuts. The other half include liquidity support, loan guarantees, and equity injections to the public sector. 

Not all countries have had sufficient fiscal space to undertake hefty fiscal interventions. The large EMEs (emerging market economies) and advanced nations constitute the bulk of the global fiscal measures, since they were hit first and hit hard. Their central banks could purchase government and corporate securities and provide massive stimulus while maintaining lower interest rates and inflation. Their treasuries were able to finance large deficits at low interest rates. Less developed economies and many small EMEs have been in a difficult position both because they have pre-existing financial constraints, or limited room for borrowing. The fiscal response, along with the collapse in revenues, is likely to push public debt to almost 100% of GDP in 2020, according to the IMF Fiscal Monitor (October 2020).

Fiscal rules during the Covid-19 pandemic

Many countries have amended their fiscal rules to provide for additional public spending to revive their economies that have been adversely hit by the Covid-19 pandemic. Fiscal rules provide a credible commitment to fiscal prudence. They set numerical limits on fiscal aggregates such as the level of fiscal deficit, public debt, or growth of public expenditure. A key feature of robust fiscal legislation is the ‘escape clause’. Such a clause allows for temporary deviation from fiscal targets in the event of unforeseen circumstances. This is in accordance with a limited number of well-defined exceptional circumstances, time limits on how long fiscal policy can deviate from the targets specified in the rule, and a requirement for fiscal policy to return to the specified targets after the escape clause is terminated. 

The IMF is of the view that the Covid-19-induced crisis will require the use of escape clauses to allow temporary deviation from fiscal rules (IMF, 2020). However, this should not be at the cost of excessive discretion that could undermine the return to fiscal prudence over the medium term. In this post, we discuss the fiscal strategies to deal with the Covid-19 shock of a set of countries that belong to the G20 group or the middle-income EMEs. These countries are broadly similarly placed as India. The set of countries that we consider are: Brazil, Chile, Colombia, Germany, Japan, Mexico, Peru, and Poland. We also look at the fiscal strategy of European Council of Economic and Finance Ministers. 

Among this set of countries, we find that Chile has been exceptional and very strict on fiscal discipline with no declaration of relaxation. The authorities consider that past fiscal prudence has been a cornerstone of their ability to respond to crises in a timely and aggressive manner. They advocate the need for responsible policies to strengthen the fiscal rule framework, going forward. Chile targets to bring back the structural deficit to 1% of GDP by 2024, from 2.5% of GDP in 2021. Mexico is also seen to be similar, from the point of view of sticking to fiscal prudence. 

All other countries in this set have relaxed their adherence to fiscal discipline amid the Covid-19 shock. While a handful of countries (such as Indonesia) have formally announced the timeline by when they propose to revert to the fiscal consolidation path, others have mentioned that such fiscal relaxation is ‘temporary’ in nature.  

On 23 March 2020, the Council of Economic and Finance Ministers of the European Parliament activated the ‘general escape clause’ in the Stability and Growth Pact (SGP).1 While the clause allows the member states to undertake budgetary measures to deal with exceptional fiscal situations, it stipulates that its application should not endanger fiscal sustainability, and that the deviation should be temporary. Noticeably, until 2020, the escape clause has never been activated since its addition to the SGP in 2011. The European Commission and the Council have already clarified that the Covid-19 pandemic qualifies as “unusual events outside the control of government”. Over half of the European countries have also activated their national escape clauses. For example, Germany suspended the constitutionally enshrined debt brake rule2 and approved a massive stimulus package. The Polish government amended the budget bill in June 2020 to include a deficit of US$29 billion, which accounts for the increased public spending needed during the pandemic. 

Among the Latin-American, emerging peers of India, Brazil has relaxed fiscal discipline. Article 65 of Brazil’s Fiscal Responsibility Legislation, 2000 provides that the commitment to comply with fiscal targets can be suspended in the event of a public calamity, which is acknowledged by the national congress in the case of the federal government, or by the legislative assemblies in the case of states and municipalities. Congress declared a state of ‘public calamity’ on 20 March 2020, lifting the government’s obligation to comply with the primary balance target (fiscal balance net of interest payments on government liabilities) in 2020. Emergency measures are being included in a separate (so called ‘war’) 2020 budget, not bound by the provisions of Brazil’s Fiscal Responsibility Law.

Colombia has decided to suspend its deficit limits until 2022. While the fiscal framework provides for a countercyclical fiscal policy response – an increase in spending if the output growth is 2% lower than the long-term growth rate – the Covid-19 shock was considered too large to be accommodated within the cyclical framework. Colombia’s fiscal framework provides for an independent advisory committee to assess the implementation of the fiscal rule. The advisory committee initially decided to widen the fiscal deficit to 4.9% of GDP in April and then to 6.1% of GDP in May 2020. 

Peru, among other Latin American countries, has prioritised boosting the stagnant economy and its growing need for health spending. In their fiscal policy plan, Peru has decided to issue bonds worth US$11.56 billion in 2021 to support their fiscal stimulus, equivalent to almost a staggering 20% of GDP. Peru has also waived its budgetary fiscal rule and the 30% of GDP debt limit for 2020-21.

Mexico has also been exceptional to double down on austerity, rejecting Keynesian fiscal expansion3 during the pandemic. When other emerging peers are spending heavily, Mexico’s proposed budget plan contains no significant spending increase. Rather, the country plans to cut total debt to 53.7% of GDP in 2021, 53.1% of GDP in 2023, and 52.6% of GDP in 2024. 

Among the Asian, middle-income emerging peers of India, Indonesia’s fiscal rule provides for limiting the fiscal deficit to 3% of GDP in any given year.  Indonesia has decided to suspend its fiscal deficit cap of 3% of GDP during 2020-2022.

Among the G20 advanced economies we look at Japan’s fiscal consolidation strategy. The Suga Cabinet in Japan approved a record high US$1.03 trillion draft budget plan for fiscal year 2021 to revitalise the economy amidst the pandemic, with an emphasis on boosting social security and health expenditure. Nevertheless, as part of its fiscal consolidation strategy, Japan prioritised bringing back the primary balance into the black in 2025.

A review of fiscal responses of a set of countries allows us to infer attributes of a credible fiscal framework. First, fiscal rules of most countries allow for the conduct of countercyclical fiscal policies, that is, in times of economic downturn, fiscal rules do allow for deviation from the fiscal targets through enhanced public spending and fiscal deficits. These are usually provided through precisely drafted escape clauses. 

Second, the activation of escape clauses require parliamentary approval to ensure that they are used in an appropriate manner.. For example, in Colombia, the activation of escape clauses requires approval from the statutory fiscal council that assesses the macroeconomic conditions and fiscal projections. 

Third, not only the activation, but the monitoring of the implementation of escape clauses is also vested with the fiscal councils. This arrangement fosters transparency and accountability in fiscal frameworks. For example, in Peru, the fiscal council recommended that the government release a report that assesses the exceptional measures including additional spending, and explain the relaxed fiscal deficit target to the general public.

In some countries, the fiscal rules do not provide for escape clauses, or the conditions for triggering escape clauses may not envisage a severe and deep shock such as Covid-19. In these circumstances, fiscal rules could be suspended. However, the suspension of fiscal rules should be allowed only through parliamentary approval and should lay down an approximate timeframe by which the suspension would be terminated. For example, Indonesia has pledged to return to the 3% fiscal deficit limit by 2023.

A well-crafted communication strategy that conveys commitment to fiscal prudence in the medium term, helps restrict the adverse impact of high fiscal deficits.

Deviation and suspension of FRBM Act, 2003 in India

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 was enacted by the Indian parliament in August 2003. The Act came into force on 5 July 2004. The Act, and the rules made under the Act, prescribed a fiscal deficit target of 3% of GDP to be achieved by 31 March 2009. To tackle the economic implications of the global financial crisis, the finance minister, while presenting the budget in February 2009, announced the suspension of the FRBM Act. The escape clause (first proviso to Section 4) of the FRBM Act, 2003 (before the amendment of 2018) did not mandate a time path to facilitate a return to the fiscal consolidation roadmap, following a deviation from targets. Consequently, the FRBM Act, 2003 remained in suspension from 2008-09 to 2012-13. 

The budget speech of 2012-13 terminated the suspension of the FRBM Act, 2003 and proposed certain amendments to the statute. Accordingly, the Finance Act, 2012 amended the FRBM Act, 2003 to push the deadline for achievement of fiscal deficit target from 31 March 2009 to 31 March 2015. Subsequently, the Finance Act, 2015 once again amended the FRBM Act, 2003 to shift the date for achieving the 3% fiscal deficit target from 31 March 2015 to 31 March 2018. The Medium Term Fiscal Policy Statement of 2017-18 once again deferred the fiscal deficit target to 31 March 2019. Thus, it is clear that the fiscal deficit targets were deferred on a number of occasions.

In 2018, comprehensive amendments were introduced to the FRBM Act, 2003 to incorporate some of the recommendations of the FRBM Review Committee report chaired by N.K. Singh. Among other changes, the fiscal deficit target of 3% was proposed to be achieved by 31 March 2021. Another key feature of the amendment was to prescribe a relatively more nuanced escape clause. The statutory escape clause, as per the recommendations, allows the central government to deviate from the annual fiscal deficit target on grounds of national security, act of war, national calamity, collapse of agriculture severely affecting farm output and incomes, structural reforms in the economy with unanticipated fiscal implications, or decline in real output growth of a quarter by at least 3 percentage points below its average of the previous four quarters. However, any deviation from the fiscal deficit target should not exceed 1.5% of the GDP in a year. The escape clause also mandates that a statement explaining the reasons for deviation and the path of return to fiscal deficit targets should be laid before both houses of parliament.4

Even before the pandemic, the escape clause was invoked to deviate from the fiscal deficit targets. While presenting the budget for 2020-21, the finance minister used the escape clause to deviate from the fiscal deficit target of 3.3% for 2019-20. The escape clause was also used to deviate from the target for the next financial year, that is, 2020-21. Using the escape clause, the fiscal deficit was relaxed by 0.5% to 3.8% for the financial year ending 31 March 2020, and to 3.5% for the financial year ending 31 March 2021. The achievement of 3% of fiscal deficit target was shifted to 31 March 2023.

The government enhanced its borrowing requirement to Rs. 12 trillion in view of the additional spending commitment due to the Covid-19 shock. Assuming that the borrowings remain the same, the fiscal deficit is expected to be 6.1% of GDP for this financial year. While the escape clause allows the government to deviate from its fiscal deficit target by 0.5% of GDP, the deviation in fiscal deficit is likely to be much more. Hence, the government is reportedly considering amending the FRBM Act to achieve a fiscal deficit target to 4% of GDP by 2025-26. 

The economic impact of the Covid-19 pandemic is uncertain and would require large deviations from the fiscal deficit targets. An expansionary fiscal policy through tax cuts and enhanced spending is needed to mitigate the adverse impact of the present crisis. Any revision in fiscal rules should follow a transparent procedure via legislative amendment and should typically require parliamentary approval. Any suspension or amendment should be followed by a well-crafted communication strategy to explain the reasons behind the deviation from the fiscal targets and steps to be taken to revert to the medium-term fiscal consolidation roadmap.

Drawing on cross-country experience, the government could also communicate its intent to build fiscal institutions such as a fiscal Council, to impart more transparency and accountability in the fiscal framework. 

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Notes:

  1. The Stability and Growth Pact is a set of rules designed to ensure that countries in the European Union pursue sound public finances and coordinate their fiscal policies.
  2. The debt brake rule puts a cap on the additional debt that can be undertaken in a year. Under the German debt brake rule, Berlin is allowed to take on new debt of up to 0.35% of economic output.  
  3. According to Keynes, during an economic downturn, fiscal policy can respond with higher government spending and reduced taxes. An injection of government spending leads to greatereconomic activity and, in turn, spurs even more spending in the economy. Spending boosts aggregate output and generates more income. If workers are willing to spend their extra income, the resulting growth in GDP could be even greater than the initial amount of stimulus through additional government spending.
  4. See proviso to Section 4(2) of the FRBM Act, 2003.

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