Will The The New Fiscal Pact In Europe Work?

Elected government officials have a short term focus.  They like to win the next election.  Their electoral chances are enhanced when they can provide popular government programs without paying for them with taxes.  It is even better when they can also cut taxes.  Unfortunately, the policies that improve one's electoral opportunity can lead to budget deficits and fiscal problems.  That is why the eurozone operated under a central rule that limited eurozone total budget deficits to 3% of eurozone GDP.  That policy has not worked so a new fiscal rule has been established which each country must follow.  Structural budget deficits cannot exceed 1% of GDP.  That gives countries leeway to run cyclical budget deficits when revenues decline due to weaknesses in the economy.  This article explores the potential for the new policy to improve fiscal outcomes.

The major problem with the new policy is that government budget forecasts tend to be biased.  A government can forecast increases in GDP and tax revenues that are too optimistic.  Therefore, when the budget deficit fails to meet the structural budget deficit limit, they can argue that the budget deficit was caused by cyclical factors that were unexpected.

Research has shown that forecasts provided by non-government organizations are less prone to forecast bias.  If governments were bound to follow the forecasts of independent forecasters that would limit the problem of government forecast bias.  Governments, however, have other tricks that they use to disguise fiscal problems.  One trick is turn over the operation of a government enterprise to a private contractor.  That has the effect of reducing government spending on a one time basis.  It has no recurring impact when they pay a profit making enterprise to provide the same service.  Another trick is to provide temporary tax cuts to stimulate the economy.  The problem with that tactic is that temporary tax cuts tend to become permanent.  We are witnessing that problem in the US after the expiration of the Bush tax cuts.  Long range forecasts of budget deficits were lower than they would have been if the tax cuts were deemed to be permanent when they were enacted.