NZ Initiative's Khyaati Acharya calls for new official limits on government spending

Short headline: 
Encouraging sound fiscal policy

By Khyaati Acharya*

Maintaining fiscal discipline is certainly difficult.

Resisting the temptation to increase spending, particularly during an economic boom, is something that governments worldwide grapple with.

What options are there then, to usefully guard against politically expedient spending promises and better restrain politicians from exuberant spending?

The International Monetary Fund (IMF) last month released a working paper discussing the ability of expenditure rules to encourage better fiscal policy decisions.

While improving productivity growth and competition are both fundamental to lifting living standards, more robust fiscal rules could go a long way in consolidating public finances around the world.

The Global Financial Crisis represented the sharpest deterioration in public finances globally since the end of World War II.

The IMF paper emphasises that many countries found themselves between a rock and a hard place, having committed to costly, long-term policies during times of economic vigour.

It is little wonder that discussion around the role of fiscal institutions, and expenditure rules in particular, has become increasingly prevalent in the discussion on how to promote much more sound and credible fiscal policies.

Expenditure rules are lauded for their transparency and ability to be easily monitored, and are effective at bolstering fiscal performance and addressing the shortcomings of other budgetary aggregates.

Such rules are able to accommodate revenue shortfalls that result from adverse economic conditions, thus performing an important role in fiscal policy stabilisation.

They are also critical in helping to create fiscal buffers during economic booms, when the existence of revenue windfalls can make spending pressures difficult to resist.

Expenditure rules can help reduce the volatility of government expenditure and improve the predictability of fiscal policy.

Finally, they can also encourage more efficient spending decisions, particularly so in advanced economies where such rules have been attributed with higher public investment efficiency.

This is not to say, however, that expenditure rules are without their own weaknesses.

According to the IMF, between 1985 and 2012, 31 expenditure rules were introduced across 27 countries. Since then, 10 have already been abandoned.

The two key reasons for discarding expenditure rules, as noted by the IMF, are that either the country never complied with the rule in the first place, or that fiscal consolidation was successful and the government in question did not want to be restricted by the rule in good economic times.

Neither reasons are particularly commendable.

Nevertheless, with the exception of emerging countries, who likely have more pressing problems in addition to poor fiscal performance, the IMF finds that “expenditure rules have a better compliance record than budget balance and debt rules”.

Unfortunately, New Zealand is not exempt from fiscal profligacy. The current Minister of Finance Bill English has wrestled to restore fiscal surpluses now for six successive budgets, after a spending blow-out during the 2000s.

Current fiscal arrangements here do not adequately prevent poor spending decisions, even at a time where the financial pressures of the country’s ageing population demand much greater fiscal discipline.

It is reasonable to propose then, that in the search for better fiscal discipline in New Zealand, any option should encompass better spending constraints. A well-designed expenditure limit would lean against the growth in government spending and help guard against another unplanned deficit blow-out.

Careful design of such a rule is fundamental to encouraging high compliance. Empirical evidence indicates that the compliance rate is high when the expenditure rule is directly under the control of the government, enshrined in either law or in a coalition agreement.

New Zealand’s own fiscal rules are embodied in the Public Finance Act, which helps regulate parliamentary processes and decision-making. Fiscal rules are defined narrowly by the IMF as rules that set numerical limits on specific budget aggregates; they are constraints on things like public debt, spending and taxation.

But while New Zealand has budget balance rules and debt rules (although, not one that sets a numerical target) in place, it does not as yet have any expenditure rules.

Guarding the Public Purse, a report released by The New Zealand Initiative late last year, recommended strengthening New Zealand’s fiscal rules in order to make it harder for aggregate government spending to be increased without good reason.

More specific options include consideration of a spending cap rule, such as 5-to-10 year targets for future operating spending, in either per capita or a percent of GDP terms.

Compliance with such rules and targets could also be much more effective if monitored by an independent fiscal council responsible for improving the transparency of fiscal policies.

Our report recommends establishing an Office of Parliament to perform such tasks as well as monitoring the adequacy of the Executive government’s programme for responding to identified fiscal issues and risks.

Used in conjunction with New Zealand’s existing budget balance and debt rules, the IMF presents a strong case for introducing expenditure rules in strengthening fiscal performance.

While New Zealand’s fiscal outlook may not look immediately dire, poor quality spending and imminent demographic pressures make focusing on achieving and maintaining fiscal sustainability a priority.

This is because the longer these necessary fiscal adjustments are delayed, the harder they become.

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*Khyaati Acharya is a Research Assistant at The New Zealand Initiative, a public policy think tank.