The European Commission’s expenditure benchmark

The Stability and Growth Pact was meant to ensure fiscal discipline in euro area member countries. It did not happen. Nearly a quarter of a century after it went into effect, the European Commission has proposed another reform (Buti et al. 2022), with the objective of making the pact effective, simpler, transparent and owned by member countries.

In a previous Vox column (Wyplosz 2022), I expressed strong support for the proposal’s central piece – the shift from the previous focus on year-by-year implementation to a longer-term approach compatible with the definition of debt sustainability – but I argued against a rarely discussed gauge – the expenditure benchmark. This is a rather obscure concept that attracts little interest because it is purely technical, complicated to grasp, and seemingly unimportant. Yet, as with many other details of previous versions of the Pact, it stands to derail the implementation of the proposed new version, because it is complicated, not transparent, tightly controlled by the Commission, and therefore bound to be ineffective. Buti et al. (2023) state that the criticism is misplaced, without getting into any detail. In a new CEPR Policy Insight (Wyplosz 2023), I examine the painstaking details and conclude that the expenditure benchmark is quite similar to the usual measure of the fiscal stance, the change in the cyclically adjusted primary balance, but with several arbitrary elements that mix up cyclical adjustments and normative judgement.

What is the benchmark?

The construction of the expenditure benchmark involves five steps:

• Primary public expenditure (net of debt service) is cyclically adjusted, but using only the budgetary impact of unemployment gap fluctuations.
• Deviations of public investment from its past trend are netted out.
• Public revenue is subtracted from expenditure, so this is a form of budget balance hidden behind the term expenditure benchmark.
• Expenditure is further adjusted by subtracting net one-off revenues and European-financed spending, while revenue change is defined as discretionary changes, thus excluding endogenous effects of cyclical fluctuations.
• Finally, a benchmark is introduced as the resulting net expenditure measure is set to grow at the same rate as potential GDP, a dubious norm. Deviations from the benchmark are called ‘fiscal effort’.

The expenditure benchmark is meant to be a response to disenchantment with the cyclically adjust balance, which is imprecise and prone to occasional errors because the output gap suffers from the imprecision of estimates of potential GDP. But the unemployment gap is subject to the same issue and is just one of the sources of the impact of cyclical fluctuations on the budget. Ignoring the other sources cannot be a satisfactory response. Identifying one-offs and discretionary budget measures makes sense in principle, after all they are part of the standard cyclical adjustment, but these measures must be assessed because they are not observable. The Commission uses estimates provided by member states, which it either accepts as given or may wish to second guess. Either way, the procedure is opaque and unreliable.

In contrast, the cyclically adjusted balance is simpler and more transparent. It consists in estimating the output gap and its budgetary effects (using measured elasticities). Both steps are admittedly imprecise and error-prone but so are the adjustments used to estimate the expenditure benchmark. In addition, including an arbitrary benchmark confuses estimation and policy prescription. There is no presumption that the expenditure benchmark offers a better result than the cyclically adjusted budget.

How do the two estimates compare?

These two measures of the fiscal stance can be compared since the fiscal effort is a form of adjusted budget balance. Updating Carnot and de Castro (2015), it appears that the differences between the two measures are usually unsignificant. The few instances when they are significant correspond to crisis episodes when imprecision is so large that none of the measure can and should be relied upon. Another comparison focuses on the adjustments themselves. Over the long run, they must average zero. This is the case for the cyclically adjusted balance, not for the expenditure benchmark, even after excluding the benchmark which sets a target for expenditure growth. This is prima facie evidence that the cyclical adjusted balance is more reliable on average than the expenditure benchmark.

It is interesting to consider why the Commission has felt the need to develop the expenditure benchmark. It was meant to be a complement to the cyclically adjusted balance, which was found to be imprecise and to sometimes lead to pro-cyclical recommendations and to be too lax in boom years. It was mainly used for the preventive arm of the Stability and Growth Pact, when the Commission had to evaluate the budget laws of member governments year after year. It was important for the Commission to detect deviations from the requirements of the pact and to issue recommendations. Member governments could use accounting gimmicks to avoid censorship and they could argue their case by pointing out the imprecision of cyclically adjusted budgets. The expenditure benchmark was designed to circumvent these objections. By identifying the gimmicks (such as one-off measures) and focusing on explicit decisions (discretionary net revenue changes), the Commission intended to demonstrate that it relied on what governments control, not on statistical estimates. Unfortunately, these measures were derived from estimates (think of the budgetary impact of tax changes, for example) and, anyway the expenditure benchmark includes statistical estimates (the budgetary impact of the estimated unemployment gap).

With the new proposal, the motives behind the development of the expenditure benchmark vanish. The medium-term view looks at the evolution of the debt as predicted by the expected path of budget deficits. In this way, annual budgets matter little, and so does the imprecision of the estimates as long as they wash out over time. The cyclically adjusted budget fits the purpose at least as well as the expenditure benchmark and it is devoid of the arbitrary prescription regarding the growth rate of expenditure.

The importance of choosing the right measure of fiscal stance

One could conclude that this is much about nothing. If the two measures of the fiscal stance differ little, what is the problem with replacing the cyclically adjusted balance with the expenditure benchmark? Why should anyone dig deep into the way the expenditure benchmark is produced? The simple answer is that the devil is hiding in the details – the more so, the more complex they are. This is well recognised by those who have been in charge of designing and implementing the Pact:

• A former chairman of the Eurogroup wrote that “the present rules-based system of the Stability and Growth Pact has become nearly unmanageable due to its complexity, and the constant addition of exceptions, escape clauses, and other factors. This has had negative repercussions on the role and standing of the Commission and its ability to operate as a guardian of the Treaty – even beyond issues of fiscal policy governance. Needless to say, the Council has also proven unwilling to play its role under the Treaty.” (Wisser 2018)
• The Commission staff in charge of the pact noted that “[i]n order to capture all kinds of possible situations while maintaining a sufficient degree of predictability, the tendency has been to put in place incremental, detailed ex ante specifications in an elusive quest for a ‘complete contract’. (…) This approach disregarded the fact that no system could eliminate or template the necessary role of economic and political judgement in unusual circumstances or in borderline cases. Moreover, the lack of simplicity generated by this over-specification turns against its proclaimed objective of predictability.” Pench (2018)

In other words, complexity is a major reason why the Pact has failed. Complexity undermines rules because it triggers unending objections and because it clouds understanding by specialists and non-specialists alike. In a highly political environment – fiscal policy issues are among the most sensitive aspects of politics – complexity feeds misleading debates and hardens disagreements. Complexity also breeds opaqueness as, rightly or wrongly, politicians and public opinion suspect technocrats of usurping power. These remarks explain why the Commission has intended its proposal to be simple and transparent, and to buttress ownership of the pact by national authorities and polities.  The expenditure benchmark undermines this goal.

The expenditure benchmark is a perfect example of technical complexity. Just understanding how it is constructed is highly challenging. Its implementation requires many judgment calls by the Commission, which precludes ownership by governments and disenfranchises public opinions. At the proposal stage, complexity may help its adoption if policymakers are discouraged from engaging in the kind of arguments presented above. At the implementation stage, however, they will have to face up to all these complexities, they will suspect opaqueness and disown the new pact seen once again as ‘Brussels technocracy’.

This complexity is unnecessary because we have an alternative: the cyclically adjusted balance. To be sure, it is not simple either, but it is much simpler. Importantly, it is time-tested and reasonably transparent because competing estimates are routinely made available by reputed institutions such as the IMF or the OECD. It is well-adapted to the new focus on the medium term, in contrast with the expenditure benchmark that has been designed for year-by-year surveillance.

References

Buti, M, J W Friis and R Torre (2022), “How to make the EU fiscal framework fit for the challenges of this decade”, VoxEU.org, 10 November.

Buti, M, J W Friis and R Torre (2023), “The emerging criticisms of the Commission proposals on reforming the European fiscal framework: A response”, VoxEU.org, 10 January.

Carnot, N and F de Castro (2015), “The Discretionary Fiscal Effort: an Assessment of Fiscal Policy and its Output Effect”, Hacienda Pública Española/Review of Public Economics 215: 63-94.

Pench, L, S Derose, G Mourre and N Carnot (2018) “EU fiscal rules: Root causes of its complexity”, VoxEU.org, 14 September.

Wisser, T (2018) “The need for euro area reform – How to move forward”, VoxEU.org, 21 May.

Wyplosz, C (2022) “Reform of the Stability and Growth Pact: The Commission’s proposal could be a missed opportunity”, VoxEU.org, 17 November.

Wyplosz, C (2023) “The European Commission’s Expenditure Benchmark”, CEPR Policy Insight No. 121.