The IMF urges countries to adopt and respect fiscal rules that lay out numerical limits on spending, deficits, or debt, and act as guardrails to promote discipline and signal commitment to sound public finances

By Era Dabla-Norris, Raphael Lam, Francisco Roch 

Countries have increasingly adopted fiscal rules and frameworks that aim to give clarity and predictability to government spending. But these rules have not been as effective in keeping deficits and debt within their intended limits. As we show in a new report, about 40 percent of advanced economies and nearly two-thirds of emerging markets exceed their own fiscal limits.

Strong and effective fiscal rules are essential to address mounting challenges confronting countries—from record debt and increasing spending pressures on defense to aging populations and development and social needs. With these challenges, public finances are being stretched thin. Here fiscal rules can help: they lay out numerical limits on spending, deficits, or debt, and act as guardrails to promote discipline and signal commitment to sound public finances.

This is not a new idea. Fiscal rules have been used since the mid-1980s, and their use has increased over the last two decades. Today, more than 120 countries have them, according to the IMF Fiscal Rules and Fiscal Council database, covering 122 economies and 54 fiscal councils.

Our report tracks the evolution of fiscal rules and how countries comply with them. In the early years, we find that rules were too rigid and constrained responses to economic downturns. Greater flexibility was eventually introduced and proved effective, allowing governments to provide necessary support for ailing economies, particularly in severe crises such as the pandemic. However, the severe shocks were a significant test for fiscal rules, with many countries’ deficits and debt exceeding their own limits. More than two-thirds of countries have revised their fiscal rules, often making them more flexible without considerably safeguarding public finances.

Effective guardrails

For fiscal rules to be effective, they must strike a careful balance: they should safeguard fiscal sustainability while leaving adequate room and flexibility for priority spending. Our analysis shows that effective rules need to have several elements: they are based on a clear and appropriate target or fiscal anchor to guide policy; they have a robust way to correct course when spending pressures or adverse shocks put the rules off track; and there are supportive fiscal institutions to guide and support their implementation.

First, a prudent fiscal anchor—for example a debt-to-GDP ratio or a medium-term budget balance target—should be tailored within a risk framework to a country’s debt capacity and exposure to shocks. To be credible, they must be easy to monitor, clearly communicated to the public, and closely linked to annual budgets.

Second, when thresholds are breached, countries need clear procedures to get back on track. Pre-defined triggers, timelines, and policy responses can help return to fiscal rule limits—such as requiring governments to submit fiscal plans or take corrective actions—and restore discipline. Some countries go further, using progressive triggers that activate stricter measures, for example as debt nears critical levels.

This mechanism is not just good policy—it also helps countries lower their financing costs. An analysis of six countries (Armenia, Costa Rica, Cyprus, Czech Republic, Poland, and Slovak Republic) shows that well-designed correction mechanisms helped lower the cost of issuing debt by about 0.3 percentage points within six months and 0.75 percentage points within a year, compared to similar economies without effective fiscal rules.

Third, fiscal rules work best when countries have effective institutions to support and implement them. Specifically, medium-term fiscal frameworks should translate fiscal rules into multi-year plans and align short-term budgetary decisions with long-term debt goals.

Fiscal councils can also act as nonpartisan watchdogs, producing and/or evaluating government forecasts, monitoring compliance, and informing the public about the state of government finances. For example, the fiscal council in the Netherlands assesses government forecasts and evaluates the cost of policy initiatives, while providing valuable information to the public. Our analysis shows that countries with more independent fiscal councils tend to experience smaller deficits and better compliance with rules. The bottom line is this: linking annual budgets with medium-term fiscal frameworks and independent oversight can both strengthen policy credibility and make fiscal rules more effective.

Balancing discipline and spending pressures

Governments are facing increasing and legitimate demands to invest in infrastructure, public services, and economic security. Aging societies will require more spending on healthcare and pensions, and many countries are ramping up defense spending.

Putting in place fiscal rules is not inconsistent with these goals. But careful calibration and design of these rules is very important. Low-debt countries may ease their limits to support growth-enhancing spending as long as their debt remains within debt stabilizing limits. By contrast, high-debt countries need to match any new spending with revenue increases and/or reallocate existing expenditures to avoid adding to fiscal and debt risks.

As these pressures intensify, countries must strengthen—not weaken—their commitment to fiscal discipline and ensure that public finances remain a source of stability, not vulnerability.

The authors are all senior managers at the IMF. This article was originally posted here.