EU co-legislators have reached an agreement on reforming EU fiscal rules. The key change will be to make the assessment of fiscal policy more long term and country specific, with debt sustainability analysis used as an anchor. However, countries with high public debt ratios will find it exceptionally hard to meet the rules, so that many will undershoot on public investment.
Philipp Heimberger is an economist at the Vienna Institute for International Economic Studies (WIIW)
Cross-posted from Philipp’s Substack Site
This article was first appeared in the wiiw Monthly Report February 2024
After some tough negotiating, shortly before Christmas EU finance ministers reached an agreement on the reform of EU fiscal rules (Council, 2023). The Council agreement was the basis for the political deal between member state negotiators and the European Parliament on February 10th 2024. The provisional agreement by EU co-legislators will now be subject to votes in both the Council and the European Parliament, and enter into force soon after their publication. Member states will have to submit their first national plans based on the revised framework in September 2024.
The main principles of the new rules: medium term and ‘country specific’
The agreement on reforming EU fiscal rules shifts the focus from the annual development of public finances to a longer-term view. The previous framework’s well-known deficit limit of 3% of GDP and public debt limit of 60% of GDP remain, but the old annual budgetary targets, based on the ‘structural’ (cyclically adjusted) deficit, are no longer there, and the old mechanical debt-reduction rule (public debt ratios had to fall to 60% within 20 years) will also be abolished. Under the new framework, when public debt exceeds the 60% reference value, or when the budget deficit rises above the 3% reference value, the European Commission will put forward a ‘technical trajectory’. This is supposed to ensure that by the end of a fiscal adjustment period of at least four years, the public debt ratio is on a ‘plausibly downward trajectory’.
Multi-year budget plans of at least four years will be negotiated between the European Commission and national governments against the background of the technical trajectory and will be rooted in an analysis of the sustainability of a member country’s public debt. Hence, the country-specific nature of the fiscal adjustment requirements is an important change from the old framework. The net expenditure path (i.e. expenditure net of interest payments and cyclical items) will be the main operational target under the new framework. There will be a general EU escape clause and national escape clauses that can be triggered in the event of some serious occurrence that justifies temporary non-compliance with the rules.
Member states can commit to a range of investments and reforms, extending the fiscal-adjustment path to a maximum of seven years, provided the European Commission agrees that the investments are consistent with debt sustainability. However, any quantitative analysis of the medium-term fiscal and growth implications of investments underpinning a longer adjustment period is difficult and contains the potential for political conflict.
The Council agreement fails to incentivise public investment adequately, even though additional green public investment of at least 1% of EU GDP will be required if the ambitious climate targets are to be met over the coming decades. When assessing whether individual member states comply with their fiscal plans, the European Commission will exclude national spending on the co-financing of EU funded programs from government expenditure. In the short-term, this will not have a big impact, since most national co-financing relates to spending on EU regional funds. In the longer run, however, it will provide incentives for channelling extra money through the EU budget, and may increase the scope for steering national fiscal spending into EU policy priorities to increase co-financing expenditures. However, the reform compromise does not include broad exemptions for green public investment at the national level irrespective of co-financing with EU programs.
The resulting fiscal consolidation pressure from 2025 onwards will therefore make it virtually impossible for several national governments – especially those with high public debt ratios, including large euro area countries such as Italy, Spain and France – to sufficiently increase their investment ratios. Yet this is something that is badly needed if economic development and climate targets are to be met, since public investment can be reduced or postponed more easily than other government spending components whenever the pressure to pursue fiscal consolidation increases.
The insistence by Germany and certain other countries on stricter fiscal rules has led to a problematic compromise regarding the introduction of so-called ‘safeguards’ for minimum fiscal consolidation. A new ‘deficit resilience safeguard’ will be applied when the multi-year spending path is set: this will require governments to continue with fiscal adjustment – even after they have reached the 3% deficit target – until a common ‘resilience margin’ of 1.5% of GDP below the 3% deficit benchmark has been reached. This ‘safeguard’ will lead to overly harsh adjustment requirements for some member states compared to the EU Commission’s original proposals.
Implementation of the new rules could result in excessive austerity and may prove politically costly
The widespread view that the new EU fiscal rules will be lax is unfounded. The new framework will be less restrictive than would have been the case had the old framework been reactivated. After the rise in public deficits and debt due to the pandemic, the old framework would have been so harsh as to be virtually unenforceable. Nevertheless, after years of using the escape clause, it will be tough to return to fiscal restraints under the new framework; and the new rules will be much more restrictive than many believe – especially for countries with high public debt ratios. Simulations provided by Bruegel that are based on the Council agreement show that implementation of the new rules will mean Italy and Spain having to make an annual structural fiscal adjustment effort of 0.6 percentage points (pp) of GDP over a period of seven years from 2025. For France, the required annual adjustment is estimated at 0.5pp; for Austria – 0.3pp; and for Germany – 0.1pp.
Source: Zettelmeyer (2023).
The design of the new rules also demonstrates that policy makers have learnt too little from past mistakes, when lack of fiscal-policy coordination among member states exacerbated the euro crisis in the period 2011-2013. With expenditure paths derived from the Council agreement, large fiscal consolidations will be required in a number of (big) euro area countries from 2025 onwards, in order to comply with the reformed fiscal rules. Depending on where a country is in the business cycle at the time when fiscal consolidation is pursued, the cross-border effects of simultaneous budget cuts could exacerbate the adverse impacts of fiscal consolidation on economic growth. And with growth slowing, public-debt-to-GDP ratios may have a tendency to overshoot the projections of the European Commission, thereby undermining the main goal of the framework – which is to reduce public debt ratios in the medium and long term.
Given the Council agreement, better enforcement of the rules in countries such as Italy and France will not succeed in the long term without major economic and political damage. Just how unrealistic it is for countries with high public debt ratios to comply with the new rules over the long term can be seen from the fact that the political agreement provides for a transition regime for countries in an Excessive Deficit Procedure (EDP) until 2027. For instance, France has gained a concession that interest payments will be exempt from the minimum fiscal adjustment requirement under the EDP until 2027, but not thereafter. Italy argued that the reforms and investments undertaken as part of the EU’s post-pandemic recovery plan may already be sufficient to gain approval for the extension of fiscal adjustment from four to seven years; without that, even tougher fiscal consolidation would have to be implemented.
France and Italy agreed to the ‘safeguards’ advocated by Germany for short-term motives. However, future governments will have a very hard time because of this short-sighted compromise, particularly as governments will need to undershoot on public investment in order to meet the fiscal consolidation requirements. Therefore, it is likely that we will again have to discuss the political unenforceability of the reformed rules and their adaptation in the not-too-distant future.
Be the first to comment