The Legal Constraint of Fiscal Consolidation
As explained above, flexible fiscal consolidation attempts are likely to fail in a political economy. A desirable consolidation framework needs constraints imposed by legal institutions.
Since the 1990s, many developed countries have imposed some legal constraints on the reduction of fiscal deficits. The US enforced the Omnibus Budget Reconciliation Act (OBRA) to reduce medial spending and raise taxes. The US also introduced the pay-go system, which cannot raise new spending without raising associated taxes and/or reducing other spending.
In Japan, the Fiscal Structure Act was imposed in 1997 so as to reduce the fiscal deficit and government spending. Although such legal commitments are criticized in that they do not pay much attention to macroeconomic fluctuations and limit the freedom of discretionary fiscal policy, they have the benefit of making interest groups cooperate with fiscal consolidation in a political economy.
The EU and the Euro
Finally, let us explain fiscal consolidation in the EU. As explained in Sect. 2, the 28 member states of the EU have agreed to facilitate and maintain the stability of the economic and monetary union. However, following criticism regarding insufficient flexibility, the EU Council relaxed the rules in March 2005. It also made the pact more enforceable.
As a result, while the ceilings of 3 % for the budget deficit and 60 % for public debt remain, the decision to declare a country’s deficit as excessive now relies on certain parameters. The 2013 fiscal compact defines a balanced budget as one with a general budget deficit of less than 3 % of GDP, and a structural deficit of less than 1 % of GDP if the debt/GDP ratio is significantly below 60 % and less than 0.5 % of GDP otherwise.
The reason why fiscal consolidation is a matter of concern for EU monetary union is that the fiscal deficit of one country has negative externalities on other countries. There are five effects of externalities.
- 1. If one country raises the public debt/GDP ratio to an unsustainable level, other countries have to support that country in order to alleviate the fiscal crisis. This gives each country a moral hazard incentive for deficit enlargement.
- 2. Because of the financial interdependence of the monetary union, any fiscal crises hurt the financial system across the EU.
- 3. If one country issues excessive public debt, this may cause an increase in the rate of interest, inducing an increase in the interest payments of other countries.
- 4. If investors are uncertain about the true fiscal financial information of each country, a good country has an incentive to send a signal to the market that it can impose the balanced-budget principle, a rule that may not be imposed by the deficient country.
- 5. Other than economic motives, countries that have strong preferences about stable prices may have an incentive to join the monetary union based on political reasons. By excluding deficient countries from the monetary union, satisfactory countries can conduct more restrictive monetary policies in order to stabilize the price levels.
Table 6.1 summarizes the current fiscal consolidation targets in major developed countries.
Table 6.1 The fiscal consolidation targets in developed countries
The Fiscal Consolidation Targets, etc. (Fiscal Plan, etc.)
Medium-term Fiscal Plan (2013)
• Primary balance (National and local governments)
=* фТо halve the primary deficit to GDP ratio by FY2015 from the ratio in FY2010 ®To achieve the primary surplus by FY2020
• Public debt to GDP ratio (National and local governments) =» Reducing steadily after FY2021
Charter for Budget Responsibility (2014)
• Cyclically-adjusted current balance (Public sector) as a percentage of GDP
^ To be balanced by the end of the third year of the rolling, 5-year forecast period
• Public sector net debt as a percentage of GDP ^ To be fallmq in 2016-17
German Stability Programme (2015)
=> 1 less than 70% by the end of 2016, (2) less than 60% within ten years
Budget Law (2016)
• Government deficit to GDP ^ Not exceed 3% by 2017
Update of the Italy's Stability Programme (2015)
Source: Japanese public finance fact sheet. 2016 Ministry of Finance. http://www.mof.go.jp/ english/budget/budget/fy2016/03.pdf