Swedish and Swiss fiscal-rule outcomes contain key lessons for the United States.

• Author: Merrifield, John

Recent U.S. fiscal policy has created deficits and accumulated debt at an unprecedented rate. In contrast, during the same period a number of other economically advanced countries have pursued policies that have reduced deficits and the ratio of debt to gross domestic product (GDP) (Alesina and Ardagna 1998, 2010, 2013; Gobbin and Van Aarle 2001). In these countries, a key factor has been the adoption of new fiscal rules (Organization for Economic Cooperation and Development 2012, 2014). Some of these rules set limits on deficits and debt levels, and others require greater transparency and accountability for fiscal policies. The specific limits typically require structural balance aimed at preventing the accumulation of debt over the business cycle while providing exceptions for extraordinary or emergency expenditures. The most stringent new rules mandate a budget surplus over the business cycle to reduce the debt-to-GDP ratio in the medium term so that pension and health plans can be funded in the long term. Some countries have been able to significantly reduce government spending as a share of GDP and in some cases also to reduce tax burdens (Organization for Economic Cooperation and Development 2012, 2014).

The Organization for Economic Cooperation and Development (OECD) countries that have launched the new era of fiscal rules have done so to impose fiscal discipline, stabilize budgets, and accelerate economic growth (OECD 2014). But the growing belief that expansion of government is responsible for long-term widening of the variance of economic growth rates in European countries and the United States (for a survey of this literature, see Bergh and Henrekson 2011) is the more fundamental reason for increased interest in improved fiscal discipline. Andreas Bergh and Magnus Henrekson (2011) estimated that, with government size equal to total taxes or expenditure relative to GDP, a 10 percentage point rise in government size lowers the annual growth rate by 0.5 to 1 percent.

In this study, we assess fiscal consolidation and fiscal rules in Switzerland and Sweden, arguably the most effective fiscal rules in OECD countries. The Swiss debt brake continues to have a broad consensus of support in both the government and the electorate. However, support for Sweden's expenditure limit appears to be eroding, and criticism focuses on both the design and implementation of the expenditure limit. The experience in these two countries provides important fiscal-rule design and implementation lessons for other countries, including the United States.

A Public-Choice Framework

The public-choice literature provides several explanations for a deficit bias and high levels of expenditure and taxation in fiscal policy (Persson and Tabellini 2000). A deficit bias exists if over the long run the debt-to-GDP ratio rises, as has occurred in many high-deficit/debt countries (Bohn 1998; Wyplosz 2005, 2012).

Common-Pool Problems

Intra- and intertemporal common-pool problems (Wyplosz 2012) underlie democratic societies' deficit bias. The "common pool" is the revenue generated by a given tax base. The principal-agent theory in public-choice economics identifies several problems that could lead to a deficit bias as elected officials, or the agents, represent the principals, or the taxpaying citizens. In the absence of an ex ante spending cap or coordinated decision making, the principal-agent problem and prisoner's dilemma circumstances yield fiscal outcomes other than the social optimum (Buchanan and Wagner 1977; Mueller 2003; Wagner 2012). The key underlying dynamic is that independent self-denial in a commons is not reciprocated. So elected officials increase spending because other elected officials are not constrained from doing so. Fiscal rules can be designed to escape this prisoner's dilemma by requiring agreement on a budget constraint at the outset of the budget process. If a deficit bias exists only because of a coordination problem, we expect that elected officials would have an incentive to voluntarily design and implement such a fiscal rule.

When legislators make decisions on expenditures, they respond to the benefits and costs to their constituents. Their constituents almost invariably represent only part of the whole group that will bear the cost, however. A deficit bias exists because legislators take into account the full benefits of expenditures to constituents and not the full cost to the extent that these costs are shifted to non-constituents. Of increasing importance in the United States is the rise in the share of citizens who pay no taxes but who benefit from increased government spending. This situation has shifted the balance of power from citizens who pay taxes to those who pay no taxes. Fiscal rules can be designed so that legislators must take into account the full tax implications of their decisions, which can reduce spending.

An alternative common-pool problem can arise when elected officials' spending preferences differ from their constituents' preferences (Alesina and Perotti 1995, 2004; Persson and Tabellini 2000; Wyplosz 2012). There are a number of reasons why elected officials may prefer higher levels of spending than the citizens they represent. Because the benefits of the higher spending can be concentrated on especially powerful special interests, whereas the costs of increased taxes and debt are spread over a larger group of citizens, self-interested elected officials may believe that a higher level of spending increases their chances of staying in office (Rowley, Shughart, and Tollison 1986; Poulson and Kaplan 1994). Elected officials may also respond to pressure for higher spending from bureaucrats who wish to maximize their agencies' budgets (Niskanen 1971). Naturally, such private and bureaucratic rent seekers will oppose fiscal rules that limit the growth of the common pool.

An intertemporal common-pool problem can occur when elected officials make tax and spending decisions that impact citizens after the officials have left office. Elected officials with a limited time in office face a moral hazard in the form of incentives to increase spending that benefits their constituents in the short run but to ignore the adverse effects of higher spending and debt on future generations. Depending on the principal-agent connection, policy makers may agree to fiscal rules that can provide the political cover to resist the rent-seeking pressures, or they may pretend to enact meaningful rules to deflect criticism of spending growth to create political cover for kowtowing to the rent seekers.

Another common-pool problem exists if the central government rescues fiscally profligate local governments (Alesina, Angelino, and Etro 2001; Krogstrup and Wyplosz 2010). Unless the central government seizes control over the local fiscal policy making, local deficit bias creates instability' in central-government fiscal policy. Conversely, the unfunded-mandate temptation is a source of local fiscal instability. Central-government policy makers can gain politically from the mandated services by shifting the mandate costs to local taxpayers.

Time Inconsistency

Time inconsistency can undermine fiscal rules. Changing circumstances can make fiscal rules obsolete (Wyplosz 2012), or the consensus that supported enactment of the fiscal rules may not survive a change in circumstances. The challenge is to design and implement fiscal rules that are strong enough to address a deficit bias but flexible enough to adjust to changing circumstances and a changing consensus in support of the fiscal rules over time.

Time inconsistency issues affect how fiscal rules attack deficits and stabilize the budget over the business cycle. The circumstances that yield cyclical deficits are somewhat predictable, so rules that aim to match deficits and surpluses over the cycle may be appropriate. But the causes and size of business cycles vary. For example, the financial crisis that triggered the Great Recession and that recession's magnitude were unpredictable. To be effective, fiscal rules must be flexible enough to address such surprises. For example, the rules could provide for countercyclical expenditures to partially offset revenue shortfalls, or they could create an emergency fund that can support financial institutions in crisis periods. An escape clause can provide for deficit spending in excess of deficit limits in a period of sharp economic contraction. In the absence of appropriate contingency provisions, support for the rules may erode enough to allow selective or wholesale evasion.

The issue of time inconsistency is even more important in designing and implementing fiscal rules for a sustainable fiscal policy in the long run (Wyplosz 2012). Fiscal rules must be stringent enough so that, despite periodic costly contingency spending, they still reduce intolerably high debt-to-GDP ratios in the long run. That is especially challenging in a now typical OECD country that faces especially strong public-pension and health-care cost pressures because of an aging population.

Fiscal Crises and Fiscal Rules

A fiscal crisis may alter the spending preferences of principal and agent (Wyplosz 2012). The instability created by a discontinuous rise in deficits and accumulation of debt will usually raise risk premiums and perhaps cause debt defaults. Citizens and elected officials may then agree on fiscal-rule revisions that will reduce deficits and debt accumulation. Even when there is a principal-agent problem in which elected officials prefer higher levels of spending than citizens, crises may yield fiscal-rule revisions motivated by the desire to preserve as much of the rent-seeking game as possible. Crisis-driven pressure to act appears to be the key reason why some OECD countries have adopted substantive fiscal-rule revisions. In this study, we focus on Swiss and Swedish fiscal rules that originated in fiscal crises in the late 1980s...