DP5809 From Deficits to Debt and Back: Political Incentives under Numerical Fiscal Rules

Author(s): Marco Buti, Joao Nogueira Martins, Alessandro Antonio Turrini
Publication Date: August 2006
Keyword(s): fiscal gimmicks, government accounting, Stability and Growth Pact, stock-flow adjustment
JEL(s): E61, H62, H87
Programme Areas: International Macroeconomics, International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=5809

Under numerical fiscal rules, such as those underpinning EMU, governments have strong temptations to use accounting tricks to meet the fiscal constraints. Given these political incentives, fiscal variables that in the past were regarded as a mere residual acquire a strategic role. This is the case of the so-called stock-flow adjustment (SFA) which reconciles deficit and debt developments. We develop a simple theoretical model where deficits and two distinct SFA components (one that could be used to reduce the deficit figures and the other to impact debt figures instead) are determined as a result of a constrained optimization by fiscal authorities. Econometric evidence provides results consistent with the model findings. The SFA component related to the purpose to hide deficits rises with the recorded deficit, while the sales of financial assets designed to keep the debt under control rise with debt and deficit. Such practices have greatly contributed to the loss of credibility of EMU?s fiscal rules. If properly implemented, the reformed Pact, which stresses durable adjustment and long-run sustainability, should help curb such perverse incentives.