A new budget rule for Germany? Christian Kastrop Federal Ministry of Finance, Germany “Die Rolle des Parlamentariers im Haushaltszyklus” Berlin, 22. Juni 2007

Outline Status quo and problems of the existing budget rule Why a reform now? Criteria for a new budget rule Proposals for a new budget rule and their compatibility with the criteria Federal aspects of a reform

Status quo Article 115 of the German Constitution Net borrowing limited to (gross) public investment Exception to the rule only in case of a “disturbance of the macroeconomic equilibrium”

Problems of the status quo Marked increase in the central government's indebtedness could not be prevented => room for manoeuvre reduced as interest payments increased. Article 115 not so much in line with the objective of long-term sustainability Methodological criticism of Article 115 –investment concept –exception rule –no enforcement during execution

Increase of public debt according to governmental levels

Why a reform now? Favourable conditions for a reform Short term: cyclical improvement of the fiscal stance and compliance with the existing budget rules (German Constitution and SGP). Medium term: structural improvement of revenues (substitution of one-off measures by tax revenues). Also: Länder are looking for early-warning system for distressed budget cases (Federalism Commission II).  Guarantees acceptance by the public.  Grand coalition may have the majority to change the constitution.

Criteria for a budget rule Limit of net borrowing Consideration of business cycle Compatibility with SGP Sustainability of public finances Future viability Essential criteria for every budget rule Technical feasibility Legal feasibility Transition to new budget rule Consideration of federal aspects Special aspects in case of Germany

Proposals for a new budget rule SGP-consistent budget rule – short: SGP-model Budget rule similar to Swiss model but with net investment concept => proposal of the German Council of Economic Experts (CEE) – short: CEE-model Soft modification of existing budget rule

Soft modification of existing rule Marginal restriction of investment concept Exception to the rule: restriction of net borrowing to amount equal to 3 % of tax revenues Pro Relatively easy to put through from political point of view, also in the Länder No transition rule necessary Contra Almost no improvement to existing rule concerning especially exception to the rule. Compatibility with SGP (3 % deficit and structurally balanced budget) not guaranteed as not primary objective of the rule. No consideration of business cycle

Limit of net borrowing Investment concept (Golden Rule)… Intergenerational equivalence principle makes sense but: –net investment concept difficult to implement (correct depreciation?), –difference between public investment and consumption, –how to handle education expenditure (no/weak correlation with output, depreciation rate, allocative distortion)?, –discussion of investment could widen debt limit, –demographic change and pay-as-you-go-benefit system increase sustainability gap and therefore counteract intergenerational equivalence principle, –productivity of private investment (as a substitute) is neglected, –only limited analogy to private sector concerning return on investment.

Limit of net borrowing … versus structurally balanced budget avoids most of the problems in conjunction with investment concept, reduces public debt in the medium term and leads to sustainable public finances, consistent with the reformed SGP, structural deficit is restricted to zero in the medium term  can be achieved by adequate composition of expenditures and revenues,  nevertheless, expenditures must be shifted to the ones that are most efficient and with highest quality persists.

Limit of net borrowing SGP-model Structurally balanced budget, but deficit of central government max. 0.25% of GDP (about € 6 bn). –Reason: sufficient flexibility for one-off effects with reforms. –Size: SGP allows max. deviation of 0.5% of GDP of overall budget (“close to balance”), Federation with social security gets half of it. => Quantitatively very similar to net investment concept. CEE-model Net borrowing up to net investment, i.e. increase of public wealth minus realisation and depreciation of public property Depreciation data from SNA

Consideration of the business cycle Both models Symmetrical consideration in both concepts according to automatic stabilizers SGP-model Cyclical adjustment according to production function approach as for SGP CEE-model Cyclical adjustment by HP-filter as in Swiss model

Compatibility with SGP Both models: 3 % deficit criterion guaranteed SGP-model to a large extent: Aim of a structurally balanced budget supported Adoption of the agreed method of cyclical adjustment of fiscal balances CEE-model partially: Aim of a structurally balanced budget might not be observed Cyclical adjustment more restrictive than production function method applied in SGP

Intergenerational justice Both models In the long run, public debt in percent of GDP will be reduced to far below of 60 % Debt reduction can be used to cover implicit liabilities Important contribution to long-term sustainability of public finances.

Future viability Both models Decreasing public indebtedness relative to GDP opens room for manoeuvre to shift expenditures towards tasks relevant to the future Improvement of quality of public finances

Legal feasibility Both models Change of constitution (Art. 115) necessary Budget rule has to be observed, non-conformity with the constitution would be detected immediately in budget draw-up. Exceptions only in extreme cases, two-thirds majority of lower and upper house of parliament as high parliamentary barrier. SGP-model Rule only for draw-up of budget. => Practicability! CEE-model Rule also for execution of budget: Balancing fund as memory and as buffer if exceeding of rule is established ex post. If balancing fund exceeds certain amount, tax increases (Federation) are automatically established.

Technical feasibility SGP-model Estimation of output gap by production function approach as for SGP. Cyclical component for maximum (cyclical) fiscal balance: Budget sensitivity × output gap Cyclical components of the budget according to SGP: tax revenues, social security contributions, labour market expenditures. Federation and social security take about 70 % of cyclical fiscal balance – as measured by tax revenues. Not prone to disputes as method of cyclical adjustment agreed by EPC

Technical feasibility CEE-model Cyclical adjustment method easier to implement: HP-filter (with λ = 100) can be calculated more easily than production function method. Cyclical factor: potential GDP/GDP But: rule more demanding because of balancing fund

Transition to the new budget rule Both models New budget rule can be introduced only when budget is balanced. SGP-model Reduction of net borrowing according to accepted obligation of annual reduction within SGP: reduction of central government’s deficit by 0.25% of GDP p.a. (approx. € 6 bn) CEE-model Less restrictive: annual reduction of central government’s deficit by € 3 bn until 2014.

Existing rule vs. alternative budget rules

Federal aspects of a reform Länder themselves started discussion about a reform, voicing different proposals. Very heterogeneous starting conditions (from distressed to balanced budgets) may hinder quick and unanimous decision. In the Länder, only tax revenues are cyclical, but these are almost evenly distributed by the financial equalization scheme between the Federal Government and the Länder. But: debt problem remains essentially a problem of the Federation as the Länder have been – in the aggregate – reducing their net debt.

Federal aspects of a reform

SGP-model Länder may adopt the rule, but need not to. Modifications are at the Länder’s discretion as long as they are compatible with SGP. CEE-model Modifications for sanctions: instead of automatic tax increases, at the level of the Länder, revenues have to be used for repayment. Because of fiscal equalization scheme, there is no exception to the rule in case of severe economic downturns.

Formulation of a new Article 115 (1)The Federation draws up a balanced budget (SGP) while taking into account the cyclical position (SGP, CEE) and net investment (CEE). (2)Exceptions are only allowed for extreme cases and require two-thirds majority of lower and upper house of parliament (CEE). (3)Details are laid down in federal law.

Perspectives Current discussion When will a decision be made? What are the chances for realisation?