Fiscal sustainability

Last updated April 25, 2024

Fiscal sustainability, or public finance sustainability, is the ability of a government to sustain its current spending, tax and other policies in the long run without threatening government solvency or defaulting on some of its liabilities or promised expenditures. There is no consensus among economists on a precise operational definition for fiscal sustainability, rather different studies use their own, often similar, definitions.^[1]^[2]^[3] However, the European Commission defines public finance sustainability as: the ability of a government to sustain its current spending, tax and other policies in the long run without threatening the government's solvency or without defaulting on some of the government's liabilities or promised expenditures.^[4] Many countries and research institutes have published reports which assess the sustainability of fiscal policies based on long-run projections of country's public finances (see for example,^[4]^[5] and ^[6]). These assessments attempt to determine whether an adjustment to current fiscal policies that is required to reconcile projected revenues with projected expenditures. The size of the required adjustment is given with measures such as the Fiscal gap. In empirical works, weak and strong fiscal sustainability are distinguished. Differences are related to both econometric techniques used for examination and variables involved.^[7]

Government's inter-temporal budget constraint

There is no consensus among economists about the correct criterion/definition to be used for fiscal sustainability. The most commonly used criterion is the government's inter-temporal budget constraint or inter-temporal equilibrium condition:

B_{t}=\sum _{i=1}^{\infty }(1+r)^{-i}PB_{t+i}

,

where $B_{t}$ is the stock of public debt, $r$ is the interest rate of public debt and ${PB}_{t}$ is the primary balance (negative of primary deficit or government revenues minus government expenditures excluding interest expenditure).

The government's inter-temporal budget constraint states that the initial debt level should be equal to the present value of future surpluses. That is, the government debt must be backed by expected future cash flows.

Many economists have voiced grave concerns over using inter-temporal budget constraint as a de facto definition or criterion for fiscal sustainability.^[8]^[9]^[10] Also, it has been shown that under plausible assumptions the inter-temporal budget constraint is in fact not the correct criterion for sustainability.^[8]^[11]^[12]

Indicators of fiscal sustainability

There are many different indicators of fiscal sustainability. The indicators measure the fiscal adjustment required to bring public finances back to sustainable track. Specifics of the indicator depend on the operational definition of fiscal sustainability and the underlying economic modelling framework employed in a study. Some of the most commonly used indicators are so-called tax gaps. For example, the infinite horizon tax gap, or S2 sustainability indicator in European Commission phraseology is defined as:

ITGAP={\frac {(r-g)(b_{t}-\sum _{i=1}^{\infty }({\frac {1+g}{1+r}})^{i}pb_{t+i})}{1+g}}

where $b_{t}$ is the debt-to-GDP ratio, $r$ is the interest rate of government debt, $g$ is the growth rate of the economy and $pb_{t}$ is the primary balance to GDP ratio.

The infinite horizon tax gap gives the adjustment required to satisfy the inter-temporal budget constraint in terms of a permanent one-time change to projected path of primary balance to GDP ratios. Thus, if ITGAP = 5%, primary balance must be greater than projected by 5% of GDP for each future year. This could be achieved by permanently raising taxes or cutting expenditures 5% of GDP. For derivations and more information, see for example,^[1]^[4]^[13] or.^[14]

Fiscal sustainability challenges

There are numerous challenges and threats to the sustainability of public finance which can range from institutional challenges ranging from creating independent fiscal institutions, fiscal responsibility laws, fiscal rules and the management of fiscal risks to changing dynamics in the demographic structure of societies.^[15]
Although these factors are significant, the core indicator of outstanding government debt in proportion to GDP is the go to metric for analyzing the health of a country's public finance sector.^[4] If a country does suffer from a high proportion of outstanding government debt then it is very vulnerable to interest shocks and a negative growth rate. For EU member states in 2016, the expected government debt to GDP ratio is above the 60%.^[4] This is expected to change with the strong support of financial independent institutions assuming they respect the SGP rules.^[4] Additionally, reforms that address the root causes of risks to fiscal responsibility take into account the costs of aging and their components.^[4]

Institutional factors

Independent fiscal institutions which act responsibly are key for maintaining fiscal responsibility but often these institutions are created or further developed in response to crises instead of proactively preventing it. For example, during the great recession new fiscal rules were introduced to counteract debt accumulation.^[16]

The question can be raised whether these economies are sustainable in the short run due to economic shocks and in the long run due to endemic problems in the structure of the system. The major challenges of the public finance sustainability consist of creating independent fiscal institutions, fiscal responsibility laws, fiscal rules and the management of fiscal risks.

A few key factors for creating stability through institutions which have been leveraged by EU member states are the following activities which the majority of fiscal councils have enacted:^[17]

Monitor fiscal performance (by checking compliance with the fiscal rules, assessing the efficiency of taxation)^[15]
Advise the government on fiscal policy matters (by publishing opinions and recommendations on fiscal policy)^[15]
Analyse the stance of the fiscal policy, both ex post by comparing the realities with the assumed targets and ex ante by evaluating the impact of fiscal policy measures to be implemented.^[15]

Demographic impacts on fiscal sustainability

The trend of demographic aging presents a major challenge to the industrialized world and an increasing number of developing countries. Recent projections developed by the UN Population Division estimate a 40 percent increase in world population and 7.8 years increase in the median age over the next 40 years.^[17] Fiscal sustainability is considerably impacted by this phenomenon but this can be triggered multiple ways. For example, shocks such as war and mass migration can dramatically alter the demographic composition of a society. In the industrialized world this trend is driven by simultaneous decreasing fertility and increasing longevity.^[17]

Old-Age Dependency Ratio

One economic indicator that is used to illustrate the share of economically inactive people in society is the old age dependency ratio. The dependency ratio is an age to population ratio of those not typically in the labor force with individuals between 0-14 and 65+ comprising the dependent part individuals between 15 and 64 measured as the productive part. This ratio is significant for determining the pressure on exerted on the productive population by the dependent population. Although longevity is an arguably positive outcome, when paired with a decline in fertility it can create higher financial stress on working people.^[17]

Key aspects that influence the age-dependency ratio:^[17]

The type of aging - decreasing fertility or increasing longevity
The type of unfunded social security system
regulation of retirement age

Political barriers for fiscal sustainability

Political actors often get in the way of financial stability due to competing interests between stakeholders that have a lot to gain through not implementing changes that would benefit society as a whole. One example of this is the financial sector in EU non Eurozone member states which benefit from trading currencies and would lose a large part of their income should their country join the eurozone. Creating independent fiscal institutions keeps these instruments out of the reach of political actors that would seek to use them for their personal benefit.

Potential for reform

The potential for states to reform their fiscal policy to ensure sustainability is typically oriented around institutional independence and covering the cost of aging over a longer time horizon.^[4] As public pension spending is the most affected by the demographic shift of aging at the EU level accounts for 11% of GDP it is critical to develop reforms that anticipate this trend.^[4] Although there is a large variation between the composition of the welfare state between member states which is reflected across current expenditure levels and projected changes to spending, states are uses a number of measures to combat this trend. The two main categories of reform in the area of pensions are altering the age eligibility for pension benefits or altering the coverage of the benefits and adjusting the size of the benefits.^[4] Altering the age eligibility for pensions can be done through legislation through increasing statutory retirement ages or it can be achieved through nudging whereby incentives are given to individuals that postpone retirement. Adjusting the size of the benefits entails reducing the benefit ratio, i.e. "the generosity of pension entitlements".^[4] These reforms can stabilize public pension expenditure but it has the potential to create tension and instability politically.

Related Research Articles

The economy of Denmark is a modern high-income and highly developed mixed economy. The economy of Denmark is dominated by the service sector with 80% of all jobs, whereas about 11% of all employees work in manufacturing and 2% in agriculture. The nominal gross national income per capita was the ninth-highest in the world at $68,827 in 2023.

In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

<span class="mw-page-title-main">Public finance</span> Study of the role of government within the economy

Public finance is the study of the role of the government in the economy. It is the branch of economics that assesses the government revenue and government expenditure of the public authorities and the adjustment of one or the other to achieve desirable effects and avoid undesirable ones. The purview of public finance is considered to be threefold, consisting of governmental effects on:

The efficient allocation of available resources;
The distribution of income among citizens; and
The stability of the economy.

<span class="mw-page-title-main">Government budget balance</span> Difference between revenues and spending

The government budget balance, also referred to as the general government balance, public budget balance, or public fiscal balance, is the difference between government revenues and spending. For a government that uses accrual accounting the budget balance is calculated using only spending on current operations, with expenditure on new capital assets excluded. A positive balance is called a government budget surplus, and a negative balance is a government budget deficit. A government budget presents the government's proposed revenues and spending for a financial year.

A country's gross external debt is the liabilities that are owed to nonresidents by residents. The debtors can be governments, corporations or citizens. External debt may be denominated in domestic or foreign currency. It includes amounts owed to private commercial banks, foreign governments, or international financial institutions such as the International Monetary Fund (IMF) and the World Bank.

<span class="mw-page-title-main">Austerity</span> Economic policies intended to reduce government budget deficits

In economic policy, austerity is a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spending, raising taxes while cutting spending, and lower taxes and lower government spending. Austerity measures are often used by governments that find it difficult to borrow or meet their existing obligations to pay back loans. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures. Proponents of these measures state that this reduces the amount of borrowing required and may also demonstrate a government's fiscal discipline to creditors and credit rating agencies and make borrowing easier and cheaper as a result.

<span class="mw-page-title-main">Government debt</span> Total amount of debt owed to lenders by a government/state

A country's gross government debt is the financial liabilities of the government sector. Changes in government debt over time reflect primarily borrowing due to past government deficits. A deficit occurs when a government's expenditures exceed revenues. Government debt may be owed to domestic residents, as well as to foreign residents. If owed to foreign residents, that quantity is included in the country's external debt.

The Stability and Growth Pact (SGP) is an agreement, among all the 27 member states of the European Union, to facilitate and maintain the stability of the Economic and Monetary Union (EMU). Based primarily on Articles 121 and 126 of the Treaty on the Functioning of the European Union, it consists of fiscal monitoring of member states by the European Commission and the Council of the European Union, and the issuing of a yearly Country-Specific Recommendation for fiscal policy actions to ensure a full compliance with the SGP also in the medium-term. If a member state breaches the SGP's outlined maximum limit for government deficit and debt, the surveillance and request for corrective action will intensify through the declaration of an Excessive Deficit Procedure (EDP); and if these corrective actions continue to remain absent after multiple warnings, a member state of the eurozone can ultimately also be issued economic sanctions. The pact was outlined by a European Council resolution in June 1997 and two Council regulations in July 1997. The first regulation "on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies", known as the "preventive arm", entered into force 1 July 1998. The second regulation "on speeding up and clarifying the implementation of the excessive deficit procedure", sometimes referred to as the "dissuasive arm" but commonly known as the "corrective arm", entered into force 1 January 1999.

<span class="mw-page-title-main">Government spending</span> Government consumptions, investments, and transfer payments

Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting, the acquisition by governments of goods and services for current use, to directly satisfy the individual or collective needs of the community, is classed as government final consumption expenditure. Government acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending, is classed as government investment. These two types of government spending, on final consumption and on gross capital formation, together constitute one of the major components of gross domestic product.

In economics, the debt-to-GDP ratio is the ratio between a country's government debt and its gross domestic product (GDP). A low debt-to-GDP ratio indicates that an economy produces goods and services sufficient to pay back debts without incurring further debt. Geopolitical and economic considerations – including interest rates, war, recessions, and other variables – influence the borrowing practices of a nation and the choice to incur further debt.

<span class="mw-page-title-main">Fiscal adjustment</span>

A fiscal adjustment is a reduction in the government primary budget deficit, and it can result from a reduction in government expenditures, an increase in tax revenues, or both simultaneously.

<span class="mw-page-title-main">United States federal budget</span> Budget of the U.S. federal government

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A government budget is a projection of the government's revenues and expenditure for a particular period of time often referred to as a financial or fiscal year, which may or may not correspond with the calendar year. Government revenues mostly include taxes while expenditures consist of government spending. A government budget is prepared by the government or other political entity. In most parliamentary systems, the budget is presented to the legislature and often requires approval of the legislature. Through this budget, the government implements economic policy and realizes its program priorities. Once the budget is approved, the use of funds from individual chapters is in the hands of government ministries and other institutions. Revenues of the state budget consist mainly of taxes, customs duties, fees and other revenues. State budget expenditures cover the activities of the state, which are either given by law or the constitution. The budget in itself does not appropriate funds for government programs, hence need for additional legislative measures. The word budget comes from the Old French bougette.

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<span class="mw-page-title-main">Canadian public debt</span> Debt owed by the government sector in Canada

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References

1 2 Krejdl, Ales (2006). "Fiscal Sustainability – Definition, Indicators and Assessment of Czech Public Finance Sustainability (Working Papers No. 2006/3)". Czech National Bank, Research Department.
↑ Balassone, F.; Franco, D. (2000). "Assessing Fiscal Sustainability: A Review of Methods with a View to EMU". SSRN 2109377.
↑ Burnside, Craig (2005). Burnside, Craig (ed.). Theoretical Prerequisites for Fiscal Sustainability Analysis. World Bank. doi:10.1596/978-0-8213-5874-0. ISBN 978-0-8213-5874-0.
1 2 3 4 5 6 7 8 9 10 11 Sustainability report 2009. European Commission.
↑ The Long-Term Budget Outlook, 2010 The United States Congressional Budget Office.
↑ Office for Budget Responsibility (United Kingdom), 2011. Fiscal sustainability report – July 2011. Archived 2016-09-23 at the Wayback Machine
↑ Wysocki, Maciej, and Cezary Wójcik. "Sustainability of fiscal policy in Poland in the period 2004–2017." International Journal of Management and Economics 54.3 (2018): 219-226.
1 2 Bohn, Henning (April 2005). "The Sustainability of Fiscal Policy in the United States". SSRN 708173.
↑ Bagnai, Alberto (2004). "Keynesian And Neoclassical Fiscal Sustainability Indicators, With Applications To Emu Member Countries (Public Economics No. 0411005)" (PDF). EconWPA.^{[ permanent dead link ]}
↑ Roubini, N., 2001. Debt Sustainability: How to Assess Whether a Country is Insolvent.
↑ Persson, Torsten (1985). "Deficits and intergenerational welfare in open economies" (PDF). Journal of International Economics. 19 (1–2): 67–84. doi:10.1016/0022-1996(85)90019-4. S2CID 153577751.
↑ Wigger, Berthold U. (2009). "A note on public debt, tax-exempt bonds, and Ponzi games". Journal of Macroeconomics. 31 (3): 492–99. doi:10.1016/j.jmacro.2008.07.003. S2CID 154039145.
↑ Escolano, Julio (2010). "A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates (Technical notes and Manuals)" (PDF). International Monetary Fund. Archived from the original (PDF) on 2016-08-21. Retrieved 2017-06-01.
↑ Sarvi, Tuukka (2011). "Some Approaches for Assessing the Sustainability of Public Finances. Master's thesis" (PDF). Aalto University School of Economics.
1 2 3 4 Adama, Alexandra (2015). "Challenges of Public Finance Sustainability in the European Union". Procedia Economics and Finance. 23: 298–302. doi: 10.1016/S2212-5671(15)00507-9 .
↑ "Public debt sustainability: An empirical study on OECD countries". Journal of Macroeconomics: 238–248 – via ScienceDirect.
1 2 3 4 5 Dedry, Antoine; Onder, Harun (17 November 2016). "Aging, social security design, and capital accumulation" (PDF). The Journal of the Economics of Ageing. 9: 145–155. doi:10.1016/j.jeoa.2016.10.003. hdl: 2078.1/145590 .

Other sources

Bernanke, Ben S. (27 April 2010). "Achieving Fiscal Sustainability". Washington, D.C.: speech at the National Commission on Fiscal Responsibility and Reform.
Calvo, Guillermo A.; Izquierdo, Alejandro; Talvi, Ernesto (2006). "Sudden Stops and Phoenix Miracles in Emerging Markets". American Economic Review . 96 (2): 405–410. doi:10.1257/000282806777211856.
Bird, Richard M. (January 2003). "Fiscal Flows, Fiscal Balance, and Fiscal Sustainability".
Ghosh, Atish R.; Kim, Jun I.; Mendoza, Enrique G.; Ostry, Jonathan D.; Qureshi, Mahvash S. (2013). "Fiscal Fatigue, Fiscal Space and Debt Sustainability in Advanced Economies". The Economic Journal. 123 (566): F4–F30. doi: 10.1111/ecoj.12010 . ISSN 1468-0297. S2CID 154107217.

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[Krejdl2006-1] 1 2 Krejdl, Ales (2006). "Fiscal Sustainability – Definition, Indicators and Assessment of Czech Public Finance Sustainability (Working Papers No. 2006/3)". Czech National Bank, Research Department.

[2] Balassone, F.; Franco, D. (2000). "Assessing Fiscal Sustainability: A Review of Methods with a View to EMU". SSRN 2109377.

[3] Burnside, Craig (2005). Burnside, Craig (ed.). Theoretical Prerequisites for Fiscal Sustainability Analysis. World Bank. doi:10.1596/978-0-8213-5874-0. ISBN 978-0-8213-5874-0.

[EC2009-4] 1 2 3 4 5 6 7 8 9 10 11 Sustainability report 2009. European Commission.

[5] The Long-Term Budget Outlook, 2010 The United States Congressional Budget Office.

[6] Office for Budget Responsibility (United Kingdom), 2011. Fiscal sustainability report – July 2011. Archived 2016-09-23 at the Wayback Machine

[7] Wysocki, Maciej, and Cezary Wójcik. "Sustainability of fiscal policy in Poland in the period 2004–2017." International Journal of Management and Economics 54.3 (2018): 219-226.

[Bohn2005-8] 1 2 Bohn, Henning (April 2005). "The Sustainability of Fiscal Policy in the United States". SSRN 708173.

[9] Bagnai, Alberto (2004). "Keynesian And Neoclassical Fiscal Sustainability Indicators, With Applications To Emu Member Countries (Public Economics No. 0411005)" (PDF). EconWPA.^{[ permanent dead link ]}

[10] Roubini, N., 2001. Debt Sustainability: How to Assess Whether a Country is Insolvent.

[11] Persson, Torsten (1985). "Deficits and intergenerational welfare in open economies" (PDF). Journal of International Economics. 19 (1–2): 67–84. doi:10.1016/0022-1996(85)90019-4. S2CID 153577751.

[12] Wigger, Berthold U. (2009). "A note on public debt, tax-exempt bonds, and Ponzi games". Journal of Macroeconomics. 31 (3): 492–99. doi:10.1016/j.jmacro.2008.07.003. S2CID 154039145.

[13] Escolano, Julio (2010). "A Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates (Technical notes and Manuals)" (PDF). International Monetary Fund. Archived from the original (PDF) on 2016-08-21. Retrieved 2017-06-01.

[14] Sarvi, Tuukka (2011). "Some Approaches for Assessing the Sustainability of Public Finances. Master's thesis" (PDF). Aalto University School of Economics.

[:1-15] 1 2 3 4 Adama, Alexandra (2015). "Challenges of Public Finance Sustainability in the European Union". Procedia Economics and Finance. 23: 298–302. doi: 10.1016/S2212-5671(15)00507-9 .

[16] "Public debt sustainability: An empirical study on OECD countries". Journal of Macroeconomics: 238–248 – via ScienceDirect.

[:0-17] 1 2 3 4 5 Dedry, Antoine; Onder, Harun (17 November 2016). "Aging, social security design, and capital accumulation" (PDF). The Journal of the Economics of Ageing. 9: 145–155. doi:10.1016/j.jeoa.2016.10.003. hdl: 2078.1/145590 .

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