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Journal number 1 ∘ Sulkhan Tabaghua
Fiscal Rules Nexus Covid19 shock in case of Georgia (Macro Approach)

Abstract

Empirical experience, deficits, and debt amounts in many countries show that governments spend more than they can afford. To reduce this risk and ensure long-term macroeconomic stability, most countries have periodically established legal restrictions on fiscal parameters, known as "fiscal rules". Macroeconomic approach of fiscal rules assessment relatively new subject of scientific research. Furthermore, rules-based macroeconomic policies are trending, and research around these issues has become more common in recent times. Covid19 shock led to a reduction in economic growth, a deterioration in a number of macroeconomic parameters (notably, deviation from debt and budget deficit rules), and fluctuations in fiscal rules. The pandemic (Covid19) has been a massive test of the fiscal rules. Flexibility, Activation of escape clauses in response to pandemic (covid19) challenges defended as a main macroeconomic channel for successful anti-crisis economic policy development and implementation.

        Covid19 shock on aggregate supply-demand push the economy into a new general macroeconomic equilibrium, highlighting the importance of conducting in-depth analysis of the fiscal rules, reassessment, innovative analysis of traditional economic approaches, macroeconomic policies, and scientific research on these issues.

        This paper focuses on the macro approach of fiscal rules, analyses the impact of the Covid19 shock on fiscal rules, and emphasizes their effectiveness during the crises.  With that in perspective, an study of Georgia's fiscal rule characteristics is conducted.

                Keywords: Fiscal Rules, Covid19 Shock, Debt, Deficit, Georgia.

1. Introduction

      Main macroeconomic instruments for stabilizing economic cycles known as monetary and fiscal policy. The legal environment, along with other factors, has a significant impact on their effective functioning and macroeconomic stability of countries. In the monetary area, since the early nineties, an increasing number of countries have adopted inflation targeting, exchange rate and etc. In the fiscal area, a parallel trend is under way, as rules to eliminate or contain the budget deficit, ceiling of expenditure or public debt are gaining considerable popularity in various parts of the world. Thus, some aspects of rule-based policies were the subject of earlier researches (e.g., the K-Percent Rule-Milton Friedman, Ricardian Equivalence; Ricardo-Barro Effect, and Laffer Curve).

        In order to ensure long-term economic stability and support economic growth, countries have established legal restrictions on macroeconomic parameters (debt, expenditure, deficit and revenues) which significantly reduce the possibility of exceeding the quantitative or qualitative limits set by the different laws (Constitutional, International Treaty, Statutory, Coalition agreement, Political commitment) at the different levels (e.g., national rules, supernational rules). In economic literature, this type of limitation is known as „fiscal rules “.  Fiscal rules may focus on different elements of government fiscal performance: revenues, expenditures, budget balance, and public debt [OECD, 2013]. Fiscal rules typically aim at correcting distorted incentives and containing pressures to overspend, particularly in good times, so as to ensure fiscal responsibility and debt sustainability[1].

        Before the covid19 pandemic, dissemination of fiscal rules around the world took place in three stages: the first covered the first half of the 1990s and was associated with the debt crises and the need of budget corrections in the Eurozone countries. The second stage - comes at the beginning of the 2000s and is caused by the emerging problems in developing countries. The global financial crisis of 2008-2009 made it clear that states were not following established fiscal rules, and as a result, the third stage began - the revision of existing rules, raise the level flexibility, allowing for a more efficient response to economic fluctuations.  flexibility is especially important in rare cases with large fiscal or economic impacts, such as the 2020 global (сovid19) pandemic.

2. Literature Review

        The debate about fiscal rules is not a recent phenomenon. For instance, referring to 18th century United Kingdom, David Hume (1742) stated that “… either the nation must destroy public credit, or public credit will destroy the nation”. The oldest fiscal rule is the simple balanced budget rule, succinctly stated for the first time in modern times in the “treasury view” of 1929 [Clarke, 1988]. However, the Great Depression highlighted the untenable nature of this rule during severe recessionary times. Thus, following the Great Depression, rules gave way to discretionary fiscal policy in the 1940s, 1950s and 1960s. Keynesian economics and Abba Lerner’s “functional finance view” emphasized that government should not focus on balancing the budget, but rather on balancing the economy; the budget will then take care of itself [Lerner, 1951]. These views provided the theoretical underpinnings for discretionary fiscal policy. “The principle of balancing outlays and receipts at a hypothetical income level would be substituted for the principle of balancing actual outlays and receipts” [Friedman, 1948]. Different authors also had different definitions of what constitutes fiscal rules, but all definitions implied a constraint of fiscal policy actions over time [Buti, Giudice, 2004; Drazen, 2004; Kell, 2001; Milesi-Ferretti, 2003; Siebrits, Calitz, 2004; Tanner, 2004, Kopits, 2004], some authors view fiscal rules as restrictions on budget deficits, the level of public debt or government expenditure [Zharku, 2018; Kregždė, 2013]. Despite the differences of opinion mentioned differences do exist as to whether rules should be permanent or could also include temporary restrictions (e.g., the 3% stipulation of GEAR, the “Growth, Employment and Redistribution” strategy of the ANC-led government in South Africa in 1996) and whether rules should be contained in policy statements or also encoded in law [Kopits, Symansky 1998]. Most popular definition of fiscal rules defined by Kopits and Symansky [1998] “fiscal policy rules are a permanent constant of fiscal policy, expressed in terms of summary indicator of fiscal performance, such as the government budget deficit, borrowing, debt or a major component thereof”.

        Additionally, efficiency of fiscal rules becoming the subject of scientific researches [Ayuso-i-Casals, 2012; Darvas, Martin, Ragot, 2018; Thygesen, Beetsma, et al. 2020; Arbatli, Moretti, Sanya, 2022; Luc, Hodge, Ralyea, Reynaud, 2020; Wolf, 2015; Abu, David, Gamal, Obi, 2022] and this process was stimulated by the economic crisis and covid19 shock [Muchiashvi, Shonia, 2022:53-58; Kakhidze, Meskhoradze, Chagelishvili, Fifia, 2020; Davoodi, et al. 2022; Blanchard, Leandro, Zettelmeyer, 2021; Blanchard, 2019; Claeys, Leandro, Darvas, 2016; Grosse-Steffen, et al. 2021; Schaechter, Andrea, Kinda, Budina, Weber, 2012].               

3. Fiscal Rules Characteristics and Dataset

3.1. Characteristics

         A fiscal rule has two fundamental characteristics. First, it presents a constraint that binds political decisions made by the legislature and by the executive. And second, it serves as a concrete indicator of the executive’s fiscal management. While fiscal rules can help governments to achieve fiscal objectives and discipline, there is no one-size-fits-all rule for every country.  Following types of rules are in place:

  1. Numerical fiscal rules - are lasting constraints on fiscal policy through predetermined limits on aggregate fiscal indicators. Rules are generally defined as fixed numerical limits (floors or ceilings) on fiscal variables set in legislation and binding for at least three years;
  2. Procedural rules - that set standards on how the annual budget should be prepared and executed, for instance, by setting and enforcing expenditure ceilings at the ministry level. Procedural rules that can be found in many countries to ensure the execution of either discretionary or rules-based policies. Procedural rules include automatic contingency measures, such as across-the-board cuts in noninterest spending (usually, but not always, excluding transfers under mandatory programs), cash limits, sequestration of funds, or imposition of a surtax.

      Above mentioned rules are design by different ways with probability of mutual impact, which has same goals related to stimulating macroeconomic stability and economic growth:

a)    Budget balance rules (BBR) - ceiling on the overall budget deficit, are relatively easy to monitor and implement and can support debt sustainability. However, if specified in nominal terms, budget balance rules do not have macroeconomic stabilization properties and tend to lead to procyclical fiscal policy;

b)    Debt rules (DR) - ceiling on the debt-to-GDP ratio or a debt brake mechanism, safeguard fiscal solvency by linking the fiscal stance to debt sustainability over the medium term;

c)    Expenditure rules (ER) - ceiling on nominal expenditure growth, are operationally simple and provide clear guidance on how to adjust the fiscal stance over time;

d)    Revenue rules (RR) - floor or ceiling on revenues, seeks to increase revenue collection or avert an excessive tax burden.

3.2. Dataset

        As of 2015, the longest lasting fiscal rules in the world were those of Japan (69 years), Malaysia (57 years), Singapore (51 years), Indonesia (49 years), and Germany (42 years). In contrast, the median duration of national rules among all other countries is 9 years, and the duration for supranational rules, such as those of the European Union, is about 11 years [Caselli et al. 2018].

        During the past two decades, a growing number of countries across the world have adopted rules-based fiscal frameworks. As of end-2021, about 105 economies have adopted at least one fiscal rule, 11 countries more than the last update in 2015 and 96 countries more than 1985. Two advanced countries were frontrunners on the adoption of fiscal rules, but it is increasingly common in emerging market and developing economies especially since the late 2000s. As of end 2021, there are more than twice Emerging Markets and Developing Economies (EMDEs) than advanced economies with fiscal rules [Davoodi, et al. 2022].

       Role of fiscal rules for countries sustainable development increased periodically. Different experience shows slightly different approach and for defining numerical or procedural limitations for stimulation economic growth and fiscal policy effectiveness, moreover most widen fiscal rules among the 106 countries analyzed is debt rule (Figure 1).

Figure 1. Fiscal Rules Dataset

1. Number of Countries with Fiscal Rules            2. Number of Countries by Fiscal Rules Type


 

    Source: Fiscal Rules Dataset 1985 - 2021, IMF. 

      According to the best practice of countries debt rules set a maximum on the debt-to-GDP ratio, which is often set at 60% of GDP and budget rules defined as 3% of GDP.  Scientific research focusing on fiscal rules in the case of different countries is investigating the effectiveness of this restriction. Ghosh et al. [2013] finds much lower “steady” or long-run debt ratios for euro area countries (on average for the panel, 62% or 74% of GDP depending on the assumptions) compared with default inducing debt limits. Checherita-Westphal et al. [2012] finds an optimal debt ratio of 50% of GDP for a panel of euro area countries based on average estimates for the output productivity of public capital. Similarly, Fall et al. [2015] find an “optimal” debt level related to the role of government debt in financing public infrastructure at 50-80% of GDP. Maastricht Treaty concerning the ceiling of 3% of the EU member state budget deficit is not sufficient to have a steady or non-increasing state of the debt of Lithuania [Kregždė, 2013]. Safe debt level for Georgia is the range of 35-40% of GDP would be consistent with overall deficits of about 2.3-2.7% of GDP [IMF, 2018].

4. Georgian Fiscal Rules

        After the collapse of the Soviet Union, all its member states, including Georgia, embarked on economic modernization. Which naturally started by changes the legislations framework of economic activity. Main focus of the economic policy of Georgia is to increasing economic freedom by reducing the government’s participation in the economy. Economic freedom is a key principle of economic policy, reflected in: small size of government, responsible macroeconomic policies, and low taxes. Although reducing government participation in the economy, fiscal and monetary reforms are the main goals of all government economic programs.  

     Above mentioned ideas incorporated in Georgian "Economic Freedom Act" adopted in 2011 (entered into force from 31 December 2013). As stated by the law government provides the economic rights and freedoms, which are the basis for the development of society, for the people’s well-being and long-term economics’ stable growth, moreover freedom is a basic principle of economic policy, which envelope in the government’s small size, responsible macroeconomic policies and in low taxes. For achieving those targets and supporting economic sustainability, the same low-defined fiscal rules, which are reasonable to divide in first and second generation. Main differences between those applies to numerical rules, namely present time two numerical rules are into force: Debt rules and Budget balance Rules. Expenditure Rules was withdrawn from first January, 2019. Moreover, in second generation rules (applied period 1 January, 2019 – present) adopted changes have affected to calculation methodologies of numerical rules and in case of budget balance rules the fundamental aggregate indicator, such as the calculation of the deficit in respect to the aggregated budget, which, unlike the consolidated budget, also includes the deficits of the budgets of the central, autonomous republics and municipalities’ legal entities of public laws, was increased by changing the calculation methodology, Additionally, the second generation debt rule's calculation methodology was modified by including state organization debts, removing national bank debts, and changing the aggregate indicator from state debt to government debt (Table 1). 

     Type of fiscal rules

First Generations (applied period 31 December, 2013 – 1 January, 2019)

Ceiling

Methodology

Characteristics of Aggregate Indicator

Numerical Rules

Debt Rule

60% of GDP

State debt’s share of GDP

State Debt - The total amount of domestic and external debts, expressed in the national currency, taken through agreements entered into by the Ministry of Finance of Georgia on behalf of Georgia and, with guarantees provided by the Ministry of Finance, by other bodies/institutions, also in amounts received from the placement of government securities denominated in the national and foreign convertible currency by the Ministry of Finance of Georgia on behalf of Georgia and received from the financial resources approved by the International Monetary Fund for Georgia.

Budget balance Rules

3% of GDP

State consolidated budget deficit’s share of GDP

Consolidated Budget – consolidated budget of the State, an autonomous Republics and Local Authorities of Georgia. Consolidated budget is not subject to the approval by the Representative Bodies of any Authority.

Expenditure Rules

30% of GDP

Share of total of the consolidated budget expenses and the growth of non-financial assets of GDP

 

Procedural Rules

Revenue Rule

N/A

The introduction of a new type of national tax, except for excise tax, or the introduction of an increase in the upper margin of the rate according to the type of national tax, except for excise tax, shall be permissible only through a referendum.

 

Second Generation (applied period 1 January, 2019 - present)

Numerical Rules

Debt rules

60% of GDP

Government debt’s share of GDP

Government Debt equals to State Debt minus obligations taken by the National Bank of Georgia

Budget balance Rules

3% of GDP

 

Aggregated State Budget – consolidated budget of the central, autonomous republics and local authorities. Aggregated State Budget is not subject to the approval by the Representative Body of any authority

Expenditure Rules

N/A

N/A

Withdrawn

Procedural Rules

Revenue Rule

N/A

Remain unchanged

Remain unchanged

 4.1. Response to the Economic Crisis

          The pandemic (covid19) led to the activation of escape clauses to temporarily suspend the rules within the fiscal framework, allowing for flexibility to adopt extraordinary fiscal support to households and firms.  Fiscal rules are long-lasting constraints on fiscal policy aimed at providing a credible commitment to fiscal discipline. At the same time, fiscal rules must be sufficiently flexible to manage unexpected economic or other large shocks [Eyraud et al., 2018]. This is particularly relevant for rare events that can have very large fiscal and economic impacts, such as the current pandemic, and will likely require escape clauses to allow temporary deviations from the rules. When to activate the escape clause? The events triggering the activation of an escape clause should be outside government’s control and preferably defined in quantitative terms if possible. They typically include severe economic downturns, large natural disasters, and states of emergency. It is also important for the credibility of the rules that escape clauses are only activated when necessary to respond to the events - that is, the size of the deviation should be linked to the policies directed at the crisis [Gbohoui, Medas, 2020]. 

      These constraints are useful to address deficit biases (that can lead to excessive debt levels) and procyclical policies (exacerbating economic cycles), ultimately helping promote more prudent and stabilizing fiscal policies. At the same time, fiscal rules must be sufficiently flexible to manage unexpected economic or other large shocks. This is particularly relevant for rare events that can have very large fiscal and economic impacts, such as the current pandemic, and will likely require escape clauses to allow temporary deviations from the rules. While the high degree of uncertainty around this crisis calls for greater flexibility, this should not be at the cost of excessive discretion that could be abused and undermine the return to the fiscal rules over the medium term. In addition, some countries either do not have escape clauses or may need to consider suspending their rules without a well-defined process or even abandoning or revising the rules.

       Before the pandemic hit, two thirds of countries with fiscal rules had included escape clauses, a notable rise relative to previous decades across all income groups and among supranational and national fiscal rules. 12 countries - activated the BBR escape clause in 2020; 10 countries - BR; 9  countries - EX; and 1 country - RR[2].

    Escape clause is one of the most important channels for developing anti-crisis economic policy in case of many counties.  At the same time, its effectiveness is significantly dependent on the legal framework, in which the basics for its implementation. Georgian fiscal rules define the following criteria describe the pre-requirements for activating the escape clause:

  1. In case of the need to finance, liquidation or damage measures as a result of the state emergency or war declared in accordance with the rules established by the legislation;
  2. In case of slowdown/recession - if according to the data published by the National Statistics Office of Georgia, the real economic growth rate of the last two consecutive quarters is 2 percentage points lower than than the average real economic growth rate of the last 10 years.

          At the same time in case of escape clause activation Government of Georgia shall submit to the Parliament:     

  1. A plan to return to the parameters defined by law. The duration of this plan should not exceed 3 years;
  2. After the end of the fiscal year reporting, in case of violation of fiscal rules (except cases prescribed by law) reporting about that with draft annual budget performance report;
  3. Information about on the causes of the violations;
  4. Information on the current budget execution and, consequently, its impact on the parameters of the consolidate  state budget in the direction of compliance with defined marginal dates.

4.2. Deviations from fiscal Rules (initial modeling)

      Deficits and debt in many countries surged during the pandemic or financial crisis’s, leading to fluctuation of fiscal rule limits [Davoodi, et al. 2022:14). Both of them are very commonly used by governments in different countries. But debt rules are particularly mutual in developing economies, with over 80 percent of EMDEs having adopted them. The majority of national debt rules is set as a debt limit or ceiling, while a minority (about 10 percent) uses a (medium-term) anchor concept (Finland, United Kingdom). Most countries have the debt rule expressed in percent of GDP, and sometimes the debt rule is set in net present value terms for low-income countries, as they receive a significant share of concessionary financing. Budget balance rules accounting for business cycles are more predominant in advanced economies (Czech Republic, Estonia) than emerging markets (Chile, Colombia). Even for the former group, assessing the output gap in real time is challenging. For those EMDEs that have deficit limits accounting for economic cycles, they often rely on thresholds on actual activity rather than a measure of output gap [Burger, Marinkov, 2012].

      Georgia experienced the same negative consequence, debt increased by 20.7% in 2020, compared to 2019. The same year's deficit, similar in comparison, increased by 7.2%. In 2021, the amount of debt is in line with the defined rule, although the amount of deficit is over the ceiling, which are prone to large covid19 negative shocks, in 2020, before the pandemic actual size of budget deficit and debt where below defined amount.

       For assessing deviations from fiscal rule limits, we apply methodology developed by different authors [Delgado-Téllez, et al. 2017; Kalan, et al.  2018; Nandelenga, et al. 2020; Alesina, Bayoumi, 1996; Fatás, Milhov, 2006; Eyraud, et al. 2018;  Grosse-Steffen, et al. 2021]. Deviations from the debt rule are defined as gross debt minus the rule limit or anchor levels. Formally, the deviation from rule X in country i and year t is given  , where X is either the budget balance rule or debt level as a percent of GDP. 

       Figure 3 show the distribution of deviations from the deficit and debt rule limits in Georgia over the period 2011-2021. Positive deviations mean the deficit and debt levels are higher than the limits prescribed in the fiscal rules. The vertical axis shows the density function.

      Figure 2. Distribution of Deviations from Fiscal Rule Limits, 2011- 2021

1. Debt Rule (DR) 

2. Budget Balance Rule (BBR) 

 

Source: Authors estimates 

5. Concluding Remarks

The research led the author to the following conclusions:

                a) given the legal limitations on significant macroeconomic parameters, it is important for many countries to maintain a socio-economically stable environment and reduce the risk of governmental accumulation of significant economic power, which is also significant for maintaining a sufficient level of economic freedom and stimulating economic growth. Covid19 introduced new challenges to fiscal rules that had previously been broadly tested by economic cycles. However, many countries' deficits and debt-defined ceilings exceed them due to cyclical fluctuations in the rules. At the same time, there is quite a bit of economic literature where the effectiveness of the maximum limits set by quantitative fiscal rules, in particular, has not been in deep assessed. Covid19 shock on aggregate supply and demand push the economy into a new general macroeconomic equilibrium, highlighting the importance of conducting in-depth analysis of the cyclical fluctuation of rules, reassessment, innovative analysis of traditional economic approaches, macroeconomic policies, and scientific research on these issues. The Covid19 shock caused activation of escape clauses and fluctuation of fiscal rules. In the wake of declining economic growth and rising social spending, there have been breaches of fiscal rules. The size of the fiscal deficit, as well as the external debt rate, will continue to be the primary focus of macroeconomic policy;

                b) Georgian fiscal rules have a short history. Fiscal rules remain the primary factor determining the country's macroeconomic sustainability. Recent amendment in legistaltion increase the fiscal rules' flexibility and provide more detailed information about the calculation methodology, notable changes applicable to debt and deficit, and escape clause activation conditions. Furthermore, pre-pandemic conditions for fiscal rule compliance raise the prospect of recovery. Distributions of deviations from the deficit and debt rule limits in Georgia over the period 2011-2021, emphasis mainly positive deviations from the deficit, thus in case of debt rules deviation are in overall negative. 

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[1]See: IMF

[2]See: IMF, Fiscal  Rules Dataset.