Economics Department

Achieving prudent debt targets using fiscal rules

 

 

Debt targets can serve as a fiscal policy anchor to ensure the sustainability of fiscal policy and that there is sufficient policy room to cope with adverse shocks. Prudent debt targets provide the commitment tool that re-assures markets and thereby diminishes risk premia and the cost of active fiscal policy.

Achieving prudent debt targets using fiscal rules, Policy brief

Prudent debt targets and fiscal frameworks, Long paper

Governments should target prudent debt levels and fiscal rules will help get there, Press release

 

Fig 1: Public debt ranges under a prudent scenario
Panel A. Prudent debt levels

Panel B‌. Average annual primary balance between
2014 and 2040

Note: The thick horizontal lines show the median debt level, boxes show the interquartile range, and extreme values are the 5th and the 95th percentiles. Only those countries that need to generate a primary surplus are shown.

Figure 2: Debt limits

Government financial liabilities, % of GDP

Source: Fall, F. and J-M. Fournier (2015), Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules

An assessment of the effect of debt on economic activity suggests that beyond a debt threshold, government debt can undermine economic activity and the ability to stabilise the economy:


More specifically, the empirical cross-country evidence suggests different debt thresholds, defined as the turning point at which negative effects of debt on the economy kick in, for three groups of countries:

 

  • For higher-income countries, a debt threshold range of 70 to 90% of GDP.
  • For euro area countries, the debt threshold is lower, as they do not control monetary policy. Given the no-bail-out clause, the absence of debt pooling, a higher dependency on foreign financing and difficulties in adjusting to shocks, the debt threshold is 50-70%.
  • For the emerging economies the threshold is even lower at 30 to 50% debt of GDP as they are exposed to capital flow reversals.

Prudent debt targets should be set to avoid an overshooting of the debt thresholds in the case of adverse shocks. Prudent debt targets take into account uncertainties surrounding macroeconomic variables and are thus country-specific. Prudent debt targets are on average 15 percentage points lower than debt thresholds (Figure 1).

 


The prudent debt target should serve as the reference point to define numerical fiscal rules. The fiscal rules should have two objectives: promote fiscal discipline and permitting stabilisation policies. There is a trade-off between these two objectives.

 


A combination of a budget balance rule and an expenditure rule seems to suit most countries well. A budget balance target encourages hitting the debt target. And, well-designed expenditure rules appear decisive to ensure the effectiveness of a budget balance rule and can foster long-term growth.

 

Note to figure 2: The long-term recession risk is the probability of GDP per capita growth to become negative. The uncertainty surrounding the debt trajectory is assessed by the interquartile range of the debt level in 2040. The “Constant primary balance” simulation is a stylised scenario in which the actual primary balance is kept constant such that the prudent debt target is reached, with no automatic stabilisers. In the scenario labelled “Automatic stabilisers”, a one percentage point negative surprise in the output gap is associated with a 0.4% of GDP stimulus.

The main papers providing background to this note are:

Fall, F., D. Bloch, J.-M. Fournier and P. Hoeller (2015), Prudent Debt Targets and Fiscal Frameworks
Bloch, D. and F. Fall (2015), Government Debt Indicators: Understanding the Data
Fall, F. and J-M. Fournier (2015), Macroeconomic Uncertainties, Prudent Debt Targets and Fiscal Rules
Fournier, J-M. and F. Fall (2015), Limits to Government Debt Sustainability

 

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