Following a major fiscal policy review, Sweden has recently announced that it will legislate a fiscal rule in respect to the budget balance. This represents a significant development in a much-admired fiscal policy framework which was introduced more than a decade ago, during a period of major fiscal consolidation. Central to the Swedish framework as it has operated to date has been a system of fixed medium-term aggregate expenditure ceilings. These ceilings have been informally linked to a target of a 1 percent budget surplus over the business cycle. What the new approach will do is to transform that budget balance target into a binding fiscal rule. This is seen as a central part of the Swedish commitment to a sustainable fiscal “exit strategy” from the global crisis.
Under the Swedish framework, aggregate expenditure limits are set three years in advance and are then strictly binding. The great advantage of such aggregate expenditure ceilings is that they can restrain pro-cyclical expenditure patterns, by counteracting the tendency of governments to increase expenditure unsustainably during boom periods on the back of temporary revenue surges. Such pro-cyclical expenditure surges are a key source of fiscal sustainability problems. The aggregate expenditure ceilings have therefore been the feature of the Swedish model which has attracted the greatest degree of favorable international attention.
Under the approach which has operated in Sweden to date, the 1 percent budget surplus target has been applied ex ante, but has not been binding ex post. In other words, when the medium-term aggregate expenditure ceilings are set, they are supposed to be consistent with the 1 percent over-the-cycle budget surplus target. However, if during the period of currency of the ceilings, it transpires that the surplus target will be breached, the expenditure ceilings are not revised downwards.
Medium-term aggregate expenditure ceilings should not be confused with the notion of fixed ministry ceilings. Sweden does not translate the aggregate ceilings into multi-year commitments to spending ministries. Indeed, the move to turn the deficit target into a strict rule would make it most unwise to make such commitments, for reasons which I outlined in a previous blog piece – namely, that this would then require that any fiscal tightening required by the deficit rule take the form exclusively or mainly of tax increases rather than spending cuts.* With the introduction of a firm budget balance rule, it will be essential that the aggregate expenditure ceilings are treated only as ceilings and not as floors.
Transforming the budget balance target into a fiscal rule will also make it essential to specify precisely how the budget balance is defined for the purpose of the rule. A clear definition is currently lacking. The Swedish Fiscal Policy Council – an independent body established by the government in 2007 – has criticized the vagueness of the deficit target to date, noting that the government has used five different definitions of the budget balance with reference to the 1 percent target.
Clarification will also be required as to the way in which the deficit is defined in respect to the business cycle. It may be necessary to change from the current formulation of the 1 percent surplus requirement in terms of “over the business cycle” – respect for which can only be judged after the event – to definition in terms of a structural budget balance measure, calculated annually.
Broader debate is underway in Sweden on other aspects of its fiscal framework. One of these is the comprehensiveness of the aggregate expenditure ceilings. The Swedish expenditure ceilings have to date covered virtually all government expenditure – including cyclically-sensitive expenditure such as unemployment benefits. This largely blocks the operation of “automatic stabilizers” on the expenditure side. In other words, it prevents those automatic increases in expenditure such as unemployment benefits during a recession which help to stabilize the economy. In its comments on the 2009 budget, the Fiscal Policy Council criticized this approach, suggesting that “the expenditure ceiling should not block central government expenditure if there are compelling cyclical reasons for allowing it to increase. It would be desirable to get a crossparty agreement on the possibility of exceeding the ceiling in exceptional circumstances.” Absolutely – but a simpler approach would surely be to exclude such expenditure from the aggregate ceilings, as happens in most other countries which set fixed medium-term aggregate expenditure ceilings.
* Note that the existence of a so-called “budget margin” gives a little scope to cut aggregate expenditure under these circumstances.