Fiscal rules and procyclicality: an empirical analysis

Abstract

While it is well acknowledged and researched that fiscal rules promote fiscal discipline, there is still apprehension that fiscal rules by imposing strict constraints on fiscal spending can be procyclical and destabilising. It could happen that when the need of the hour is to increase expenditures during bad times and control expenditures in good times, fiscal rules may tempt governments to trail the opposite path. Using a panel GMM model, this paper has tried to empirically test whether the nature of fiscal rule influences this procyclicality of fiscal policy in a cross-country panel framework for 61 countries for the post 2000 period. Considering that countries have shifted overtime towards fiscal rules adjusted for cycles to reduce the procyclicality bias, the above is tested under two alternate variants of fiscal rules, i.e., those with conventional budget balance rules and those who have fiscal rules adjusted for business cycle impact usually called cyclically adjusted balances (CAB)/structural balance (SB) rules. Empirical results support that while adoption of simple budget balance fiscal rules has not been able to protect these economies from procyclical fiscal policy, the adoption of CAB/SB based fiscal rules are associated with countercyclical fiscal policy. Results of the paper, thus, support the policy conclusion that designing fiscal rules that incorporate business cycles into the target, either via well-defined escape clauses or through formulation of limits in cyclically adjusted terms, can achieve the dual objective of fostering higher growth while simultaneously maintaining fiscal discipline.