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If You Want to Cut, Cut, Don\'t Talk: The Role of Formal Targets in Israel\'s Fiscal Consolidation Efforts 1985-2008. Adi Brender Research Department, Bank of Israel. IMF Conference: Fiscal Rules for Israel. Background.

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If You Want to Cut, Cut, Don\'t Talk:The Role of Formal Targets inIsrael\'s Fiscal Consolidation Efforts 1985-2008

Adi Brender

Research Department, Bank of Israel

IMF Conference: Fiscal Rules for Israel

background
Background
  • Since the 1985 stabilization, governments repeatedly stated a commitment to fiscal consolidation.
  • Since 1992 Israel’s fiscal policy is formally guided by multiyear deficit targets.
  • Performance with respect to the targets and the actual fiscal position varied over time.
  • This paper focuses on the contribution of formal targets and policy design to performance.
the logic of multiyear targets
The Logic of Multiyear Targets
  • The original decision-maker takes most of the political “heat” for constraining the “deficit bias”.
  • Subsequent governments tend to adhere to the predetermined rule:
    • the “price” has already been paid
    • abandoning it could get the government blamed for hurting macroeconomic performance.
  • Market participants understand the “game”; Hence, the policy is credible from the outset.
underlying questions
Underlying Questions
  • Does the public really like deficits?
    • No such evidence in the literature
    • Doesn’t really make sense (rationality).
  • Can macro-fiscal targets be met without external constraints(SGP, US guarantees).
  • More reasonable to think of the “Deficit bias” as a micro phenomenon with macro consequences.
pre specified measures or macro targets
Pre-Specified Measures or Macro Targets?

Policy-makers need to confront interest groups on specific budget items.

Setting macro-fiscal targets leaves the “real battle” - approving and implementing the required measures - to future policy-makers.

  • The micro component is a key difference between monetary and fiscal targets.
israel s experience 1985 2008
Israel’s Experience 1985-2008

Examine 4 sub-periods separately: :

  • Post 1985 consolidation: no quantitative macro-fiscal targets.
  • Early 1990s: Mass immigration, adoption of formal targets.
  • 1993-2003: Fiscal targets and strong expenditure dynamics.
  • 2003-2008:Expenditure restraint and formal expenditure ceiling.
the 1985 stabilization
The 1985 Stabilization
  • Following repeated failures of government programs and intensifying crises.
  • No quantitative medium-term targets.
  • Substantial Immediate one-off measures.
  • Pre-specified medium-termprograms to cut expenditures:
      • Defense
      • Product subsidies
      • Producer subsidies
  • Legislated tax-rate reductions after the initial phase.
1991 introduction of deficit targets
1991: Introduction of Deficit Targets
  • In 1990 and 1991 Israel absorbed 380,000 immigrants (8% of the population).
  • The direct annual fiscal cost of absorption in these two years amounted to 3.5% of GDP.
  • The underlyingsurplus in 1991 – excluding one-off absorption costs - was 0.8% of GDP.
  • To show that once absorption expenses phase-out other expenditures will not rise, a balanced budget target was adopted for 1995.
why multiyear targets
Why Multiyear Targets
  • To persuade the markets that the large deficit in 1991 and 1992 istemporary.
  • Insufficient track record of commitment to long-term fiscal consolidation.
  • The target was written into a law –to overcome time inconsistency before the scheduled elections in 1992.
  • Consistent with the emerging international norm of the time.
first government change 1992
First Government Change - 1992
  • The new government, elected in 1992, immediately raisedthe target.
  • Also: adopted expansionary medium-term policies: raised wages, transfer payments, road infrastructure and public consumption.
  • Policy costs were not fully visible until 1995-96 due to faster-than-expected decline in immigration.
the era of revised and missed targets 1995 2003
The Era of Revised and Missed Targets: 1995-2003
  • Following the first change subsequent governments kept changing the targets almost every year.
  • The targets were almost always missed.
  • Nevertheless, all the governments insisted on presenting multiyear targets with a low deficit (1-1.5 percent of GDP) at the final year – usually afterthe next scheduled elections.
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Despite a decade of declining deficit targets, the target for 2003 was similar to that of 1993.

the 2003 consolidation program
The 2003 Consolidation Program

Background

  • Deep recession, military conflict, surging yields on government debt.
  • Failed stabilization in the preceding year.
  • A decade of missed fiscal targets.

Consequently – to gain market confidence:

  • Need for a front-loaded program.
  • Need measures to sustain the consolidation over the medium-term.
slide17

1All the scenarios assumed the same interest rate and 4 percent annual growth. All figures are adjusted to the current GDP definition.

2 Based on specific measures adopted with the 2004 budget.

3 An estimate based on the measures adopted until early 2004 and actual growth for 2004-2006.

the role of targets 2003 consolidation
The Role of Targets: 2003 Consolidation
  • In 2003 the deficit target was abandoned.
  • Expenditure ceiling: introduced in 2005 but was changed several times. In no year was the budget in accordance with the ceiling.
  • Actual expenditure was well below the budget due to administrative measures affected since 2003.
  • Since 2006: tax cuts offset expenditure cuts.
performance 1985 2008
Performance:1985-2008
  • Targets can be effective even if they are missed, by setting a guideline to policy.
  • However, the dismal performance between 1993 and 2003 shows that missing the targets was not just a technicality.
  • The key to that failure was the inability, or unwillingness, to tackle the expenditure dynamics set by previous governments.
lessons from 23 years of attempted consolidation
Lessons from 23 Years of Attempted Consolidation
  • The key to success: tackling expenditure dynamics.
  • Pre-specified medium-term measures to cut expenditures succeeded in reducing the deficit.
  • Announcing macro targets without specifying the measures did not work. They were changed by each new cabinet and sometimes also within cabinets’ term-in-office.
  • Good news: Once specific measures were introduced, they survived government changes
lessons cont
Lessons (Cont.)
  • Bad News: successful programs were implemented in times of crisis and after failed attempts with less comprehensive ones.

(consistent with OECD experience)

Paraphrasing Winston Churchill:

"You can trust the government to do the right thing, after exhausting every other possibility“

  • Role of external constraint: US aid in 1985 and loan guarantees in 2003.
conclusion
Conclusion
  • Policy credibility and sustainability should be evaluated based on the expected impact of its specific measures – not stated macro targets.
  • Macro-fiscal targets may help coordination – but alone, they are not building credibility.

Looking forward: Need for clear long-term target and multiyear budget framework:

- Bypassing the target with long-term programs.

- An expenditure ceiling without a long-term target, makes tax cuts a “free-play”.

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