The EU’s Fiscal Compact aims to ensure that Eurozone governments’ finances are balanced or in surplus. In a new study, Joachim Wehner shows that budget rules alone may not help to ensure more prudent fiscal governance in the EU, and may even do more harm than good – unless they are underpinned by high-quality fiscal reporting.

Many European governments are adopting new fiscal rules that are more demanding than the 3% deficit and 60% debt to GDP limits in the Stability and Growth Pact. The Fiscal Compact requires signatory countries to enshrine in national law rules to ensure that general government finances are “balanced or in surplus”, with a structural deficit not exceeding 0.5% of GDP at market prices. In other words, the impact of economic conditions will be taken into account in assessing government budgets. Moreover, countries exceeding the 60% debt limit have to reduce their debt at an average rate of one twentieth per year. Are these rules likely to ensure better fiscal governance?

James Alt, David Lassen and I have examined the incentives for countries to manipulate their reported fiscal data in the context of the EU’s Stability and Growth Pact. One indicator of creative accounting or fiscal gimmickry is the discrepancy between changes in gross debt and annual deficits, or so-called “stock-flow adjustments”. There are various technical reasons why such a discrepancy might be expected, but if debt changes by more than annual deficits over a sustained period, or in other non-random ways, this suggests that governments may be actively manipulating reported deficits.

A core finding of our study is that in countries with low levels of budget transparency, such as Greece, debt changes systematically exceeded annual deficits in the period after the adoption of the Stability and Growth Pact. This pattern is non-existent in countries with high-quality fiscal reporting. We also find that in low-transparency countries debt changes exceed deficits when elections approach, and in response to negative economic shocks. Again, these patterns are absent in high-transparency countries. These findings suggest that fiscal rules do not work well when the institutional transparency of the budget process is low, and more broadly that transparency contains manipulation.

The Fiscal Compact does attempt to improve reporting standards, for instance with requirements for governments to report beforehand on their public debt issuance plans, and by promoting independent monitoring institutions, similar to the UK’s Office for Budget Responsibility or the Swedish Fiscal Policy Council. These are steps in the right direction, but they may not be enough. The treaty relies heavily on structural indicators, which are notoriously prone to differing interpretations and methods of calculation. Leaving estimation of output gaps and structural indicators to countries themselves may not bring about fiscal discipline without more far-reaching changes in transparency.

What types of reforms would make large-scale fiscal fraud more difficult in the future? First on my list would be substantial improvements in the frequency and reliability of in-year fiscal information in certain EU countries – in particular timely and credible monthly updates on the state of public finances. Second, national audit institutions that fail to audit government accounts within a few months after the end of the fiscal year should receive technical assistance from high-quality auditors, such as the UK’s National Audit Office. A more radical step would be to massively increase the capacity of Eurostat and to redesign it into an agency that can proactively audit national fiscal data and reporting systems.

Not all of these steps are politically palatable. However, with an increasing number of EU countries struggling to contain bond yields, governments have more incentives than ever to boost fiscal transparency.

For further information, please see: James E. Alt, David Dreyer Lassen and Joachim Wehner. Moral Hazard in an Economic Union: Politics, Economics, and Fiscal Gimmickry in Europe (9 July 2012).

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Note:  This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics.

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About the author

Joachim Wehner – LSE Government
Joachim Wehner is Senior Lecturer (Associate Professor) in Public Policy at the London School of Economics and Political Science (LSE), and a member of the Political Science and Political Economy (PSPE) research group and the Public Policy Group (PPG). He has previously worked at the Institute for Democracy in South Africa (Idasa), and as a consultant including for the World Bank and the OECD. His research interests are in the field of political economy, in particular in relation to fiscal policy as well as legislatures. He currently works on projects investigating the “competence” of economic policymakers in OECD countries; the politics and economics of fiscal gimmickry in Europe; and the effect of democratisation on service delivery in South Africa.