Public finance and fiscal policy

Economic Survey of Estonia 2009: Removing the pro-cyclical bias of fiscal policy

 

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The following OECD assessment and recommendations summarise chapter 2 of the Economic Survey of Estonia published on 20 April 2009.

 

Contents

 

Fiscal policy has been amplifying the business cycle

The period 2000–07 was characterised by rapid foreign-financed credit growth, which in turn fuelled an investment boom, especially in real estate. While credit growth contributed strongly to the overheating of the economy during 2005–07, the liberalised capital account and the currency board    although serving the country well    severely limited the options of policy-makers to manage the highly pro-cyclical capital inflows. Wages also grew rapidly in recent years, reflecting labour and skill shortages and mismatch. Even though these developments called for countercyclical fiscal policies, in practice budgets were pro-cyclical, with the government increasing expenditures and cutting tax rates during this upswing. Moreover, with some of the higher revenues during the past years being of a one-off nature, the expansionary policies worsened the underlying budgetary balance and will make achieving fiscal sustainability more challenging.

 

The government should apply rule-based countercyclical fiscal policies

The balanced budget rule that Estonia has adhered to since independence has been important in keeping its public debt at very low levels. However, it has also meant that the country has not used enough the counter-cyclical role that fiscal policy can play. While respecting the Stability and Growth Pact, in the current downturn the government should abstain from the usual practice of ad hoc expenditure cuts and allow the automatic stabilizers to operate. This is particularly important since the approved budget for 2009, which was based on a forecast of 2.8% GDP growth, will result in considerable restrictive measures to prevent an excessive deviation from the targeted balance.

 

Instead, the government should aim at balancing the budget over the business cycle. To maintain hard-won fiscal credibility, discretionary fiscal measures should be reserved mainly for longer-term issues, and otherwise be used only in exceptional circumstances such as natural disasters or severe recessions. To facilitate sustainability and efficiency of public spending, the deficit target could be accompanied by an expenditure rule, incorporated in a medium-term budgetary framework. Debt overruns stemming from lower-than-forecasted medium-term revenues or overestimating the structural part of the budget balance should be clawed back with a mechanism, which effectively targets the debt to GDP ratio, similar to the Swiss debt rule. A welcome side effect of a transition to a more flexible fiscal rule would be the development of a well-functioning government bond market, which could also play an important benchmark role for financial markets and thereby increase competition in the financial sector.
 

 

How to obtain this publication

 

The complete edition of the Economic survey of Estonia is available from:

The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.

 

Additional information

For further information please contact the Estonia Desk at the OECD Economics Department at eco.survey@oecd.org

The OECD Secretariat's report was prepared by Zuzana Brixiova and Laura Vartia under the supervision of Andreas Wörgötter. Research assistance was provided by Margaret Morgan.

 

 

 

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