What’s best for fiscal policy in the Western Balkans—rules or discretion?

Should governments be free to set fiscal policy as they see fit, or should their decisions be constrained by numerical fiscal rules, like the European Union’s rules that debt should be less than 60 percent of GDP and the deficit lower than 3 percent of GDP? And if governments are to be constrained, which are the rules that should constrain them?

These are currently crucial questions in the Western Balkans. Public debt in the region rose sharply during the global financial crisis—from 26 percent of GDP in 2008 to a peak of 54 percent in 2016—and getting it down to safer levels has since been a priority. The countries also have ambitions to join the European Union (EU), and that will require them to both have sound public finances and eventually to adopt the EU’s system of fiscal rules.

Many approaches to fiscal rules are currently to be found in the six countries of the Western Balkans. Five of the six economies have fiscal rules, though the nature of the rules varies greatly. Debt limits range from 40 percent to 60 percent of GDP. Some of the countries limit the total budget deficit; others limit the budget deficit excluding public investment or the budget deficit excluding interest payments. Serbia has a deficit limit determined by a mathematical formula that takes into consideration its potential growth. And North Macedonia has no fiscal rules, though it does apply fiscal targets.

The diversity of approaches is understandable because country circumstances vary. Half of the Western Balkan countries (Albania, Montenegro, Serbia) are dealing with high and growing public debt, while others (Kosovo, Bosnia and Herzegovina, North Macedonia) have low to moderate debts. There are also relevant differences in the countries monetary and exchange-rate regimes with implications for fiscal policy. Ideal fiscal policy would be discretionary, able to respond to changing circumstances. It would be countercyclical—generating surpluses in good years and deficits in others. But discretion is seldom exercised prudently, and it often leads to permanent deficits and unmanageable debt. Rules might be better than discretion. But can rules work if a government really wants to spend but not tax? If the rules become inconvenient, what stops the government from repealing or ignoring them? In the Western Balkans, as in other regions, self-imposed fiscal rules have been breached nearly as often as they have been followed.

Reliable empirical answers to questions about fiscal rules are hard to get. On average, countries with fiscal rules have lower deficits than countries without them. But as so often with cross-country empirical work, it’s not clear what is causing what. For example, countries with a culture of fiscal prudence might choose both to run small deficits and to enact fiscal rules as an expression of their prudence.

Recent evidence suggests that fiscal rules reduce deficits in countries that have traditionally run large deficits but increase them in countries that have run low deficits—perhaps because the limits in the rules can act like magnets. A rule that says that a deficit may be no more than 3 percent of GDP may be taken, despite its proponents’ intentions, to mean that a deficit of 3 percent of GDP is normal.

At the World Bank, we’ve looked at the fiscal rules in the region and also conducted an online survey to gauge public understanding of the rules. The analysis suggests compliance on average a little over half of the time—not great, but probably not too different from the experience of many other regions. However, getting debt to prudent levels will require doing more than just complying with the deficit rule. Albania would need to run a surplus of 0.8 percent of GDP every year to achieve its debt target of 45 percent of GDP by 2025—a lot higher than what they’ve achieved in recent years and much more than is required by the deficit rule. Serbia, which starts with somewhat less debt, could reach debt of 45 percent of GDP, and thus compliance with its debt rule, by running a constant deficit of 0.9 percent of GDP—a slightly tighter target than the average deficit its formula-based rule aims for. Montenegro would need to run overall deficits that are much smaller than the 3 percent of GDP permitted by its rule to comply with its 60 percent debt rule by 2025. Kosovo and Bosnia and Herzegovina are in a much better position because of their lower starting levels of debt (Figure 1).

Based on these and other findings, our current thinking is that policies toward fiscal rules should be guided by the following principles:

• The policies should facilitate accession to the EU. This does not mean that the countries should immediately adopt the EU’s full panoply of fiscal rules; for the moment, the approach should be simpler, and debt limits or targets should probably be lower than the EU’s 60 percent of GDP. Moreover, priority should be given to changes that will be beneficial even if accession is delayed (a no-regrets approach).
• The limits in fiscal rules should not be mistaken for targets. A deficit limit of 3 percent of GDP should not be mistaken for a guideline that says a deficit of 3 percent is usually okay. Rules should be supplemented by targets.
• And, perhaps most important, careful attention needs to be paid to making fiscal rules politically effective. Because a national government can usually repeal or ignore an inconvenient national fiscal rule, making the rule powerful requires making breaches politically significant. This, in turn, means that fiscal rules will work best if they are simple, widely understood, independently monitored, and enjoy cross-party support.