[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 13.6.2006

SEC(2006) 751

COMMISSION STAFF WORKING DOCUMENTTO THE COUNCIL AND THE EUROPEAN PARLIAMENT

Annex to the COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE EUROPEAN PARLIAMENT Public Finances on EMU 2006 – The first year of the revised Stability and Growth Pact {COM(2006) 304 final}

[pic]

EUROPEAN

COMMISSION

DIRECTORATE-GENERAL FOR

Economic and Financial affairs

PUBLIC FINANCES IN EMU2006

(The complete and definitiveversion will be published asEuropean Economy n° 3/2006)

European Economy

Public Finance in EMU -2006

A report by the Commission services

SEC(2006) 751

http://europa.eu.int/comm/economy_finance/publications/publicfinance_en.htm

Acknowledgements

This report was prepared in the Directorate-General of Economic and Financial Affairs under the direction of Klaus Regling, Director-General, and Servaas Deroose, Director for the Economy of the Euro Area and the Union.

The main contributors were Elena Flores, Joaquim Ayuso Casals, Antoine Deruennes, Per Eckefeldt, Roland Eisenberg, Sven Langedijk, Fabrizio Melcarne, Laurent Moulin, Marko Mršnik, and Alessandro Turrini. Specific contributions were provided by Martin Larch and Joao Nogueira Martins, Sari Sontag and Ralph Wilkinson.

The country chapters in Part V were prepared in the Directorate for the Economies of the Member States under the responsibility of Marco Buti. The contributors were Jean-Luc Annaert, Laura Bardone, Gerrit Bethuyne, Bouke Buitenkamp, Georg M. Busch, Alberto Cabrero Bravo, Mateo Capó Servera, Pedro Cardoso, Zdeněk Čech Ivan Ebejer, Polyvios Eliofotou, Luis Fau Sebastian, Jonas Fischer, Pilar Garcia Martinez, Laszlo Jankovics, Heinz Jansen, Anton Jevcak, Barbara Kauffmann, Filip Keereman, Mart Maiväli, Carlos Martinez Mongay, Marek Mora, Michal Narozny, Mateja Peternelj, Lucia Piana, Hervé Piffeteau, Lucio R. Pench, Stéphanie Riso, Peer Ritter, José Luis Robledo Fraga, Aleksander Rutkowski, Monika Sherwood, Michael Stierle, Pietro Toigo, Charlotte Van Hooydonk, Kristine Vlagsma, Helga Vogelmann, Javier Yaniz Igal, Ann Westman.

Elena Flores and Alessandro Turrini coordinated and supervised the production of the report. Fabrizio Melcarne was responsible for statistical and editorial work. Statistical assistance was also provided by Diana Gonzalez Hernandez and André Verbanck.

Comments and suggestions by colleagues in the Directorate-General for Economic and Financial Affairs as well as by other services of the Commission are gratefully acknowledged.

Secretarial support was provided by Maria Davi-Pilato and Dominique Prins.

Comments on the report would be gratefully received and should be sent to:

Directorate-General for Economic and Financial Affairs

Public Finance Unit, with particular reference to the euro zone

European Commission

B-1049 Brussels

or by e-mail to Elena.Flores@ec.europa.eu

Contents

Executive summary 19

Part I: Current developments and prospects 23

1. Budgetary developments in the euro area and EU Member States 27

1.1. Short-term developments and prospects for the budget balance and public debt 27

1.2. Government revenue and expenditure 31

1.2.1. The fiscal stance and policy mix in the euro area 32

1.2.2. The fiscal stance and policy mix at the national level 33

2. Implementing the Stability and Growth Pact 35

2.1. Introduction 35

2.2. The excessive deficit procedure since spring 2005 35

2.2.1. The surveillance mechanisms in the euro-area countries 35

2.2.2. The surveillance mechanisms in the non euro area Member States 39

3. Overview of the 2005 updates of the stability and convergence programmes 46

3.1. Introduction 46

3.2. Medium-term objectives indicated in the Stability and Convergence Programmes 46

3.3. Growth projections 47

3.4. Budgetary plans 47

3.5. Composition of the budgetary adjustment 49

3.6. Debt projections 51

4. The long-term sustainability of public finances based on the 2005/06 updates of the stability and convergence programmes 56

4.1. Introduction 56

4.2. The approach used to assess the long-term sustainability of public finances 56

4.3. The assessment of the long-term sustainability of public finances based on the 2005/06 updates 57

4.3.1. The data used in the analysis 57

4.3.2. The quantitative indicators 60

4.3.3. The qualitative considerations 63

4.4. Main public finance sustainability challenges in Member States 64

Part II: Evolving budgetary surveillance 71

1. Codification of the agreement on the SGP reform 76

1.1. Introduction 76

1.1.1. The legislative changes to the SGP 78

1.1.2. The revised Code of Conduct 81

2. Making the revised Stability and Growth Pact operational – the preventive arm 85

2.1. Introduction 85

2.2. Setting the medium-term budgetary objectives 85

2.2.1. Country-specific MTOs in the current phase 86

Setting MTOs on the basis of debt, growth and a safety margin 86

An emphasis on current debt 86

2.2.2. MTOs in perspective: taking into account implicit liabilities 87

2.3. The adjustment path towards the medium-term budgetary objectives 90

2.3.1. The definition of the adjustment path towards the MTOs 90

2.3.2. Deviations from the adjustment path for the implementation of structural reforms 91

2.3.3. Implementation of the agreement in the 2005 Stability and Convergence Programmes updates 92

3. Making the revised Stability and Growth Pact operational – the corrective arm 95

3.1. Introduction 95

3.2. The application of the excessive deficit procedure 95

3.2.1. Preparation of Commission reports in accordance with Article 104(3) 95

3.2.2. All deficits in excess of 3 percent of GDP have been considered excessive 96

3.2.3. Initial deadlines for the correction of excessive deficits were set taking into account economic circumstances 97

3.2.4. An obligation of structural efforts, to ensure that excessive deficits are corrected in a permanent way 98

3.2.5. Improved economic dialogue between the Commission, the Council and the Member States 98

3.3. The concept of 'effective action' in the excessive deficit procedure 98

3.3.1. New definition and role of 'effective action' in the excessive deficit procedure 99

3.3.1. A broad assessment of compliance with EDP recommendations 99

4. Measurement and statistical issues 101

4.1. Introduction 101

4.2. Definition and identification of one-off and temporary measures 101

4.2.1. One-off and temporary measures in the context of numerical fiscal rules 101

4.2.2. Recent experience with one-off measures in the EU 102

4.2.3. Guidance for the identification of one-off and temporary measures 103

4.2.5. Information requirements on one-off and temporary measures 104

4.3. The estimation of new and updated budgetary sensitivities and the determination of minimal benchmarks 105

4.3.1. Updating the estimation of budgetary sensitivities and computing sensitivities for the New Member States 106

4.3.2. The computation of new values for minimal benchmarks for budget balances 108

4.4. Recent developments in the governance of budgetary statistics 112

4.4.1. Statistical governance reform is part of the SGP reform 112

4.4.2. Legislative changes related to reporting of deficit and debt levels 113

4.4.3. Progress in the availability of budgetary statistics 114

4.4.4. Institutional reform 115

4.4.5. Conclusion 115

5. New long-term budgetary projections and improvements of the analysis of the long-term sustainability of public finances 116

5.1. Introduction 116

5.2. The 2005/06 long-term projections of age-related expenditure for the EU25 116

5.3. Improvements of the analysis of the long-term sustainability of public finances 120

Part III: National numerical fiscal rules and institutions for sound public finances 123

1. Introduction 128

2. Rationale for the introduction of numerical fiscal rules and independent institutions at national level 129

2.1. Introduction 129

2.2. The deficit bias in perspective 129

2.3. Reasons for the deficit bias point to the short-term horizon of policy-makers 130

2.3.1. Explanations for the deficit bias 130

2.3.2. Recent economic and political developments might have strengthened those elements behind the deficit bias 130

2.4. How can the deficit bias be addressed? 131

2.4.1. Numerical fiscal rules 132

2.4.2. Independent institutions, other than government and Parliament, influencing the conduct of fiscal policy 132

2.4.3. Concluding remarks 134

3. Numerical fiscal rules in the 25 EU Member States 136

3.1. Introduction 136

3.2. Various types of numerical fiscal rules and their respective properties 136

3.3. Existing numerical fiscal rules in EU Member States 138

3.4. Do numerical fiscal rules improve budgetary performance? 141

3.4.1. Relation between the introduction of numerical fiscal rules and budgetary outcomes 142

3.4.2. Relation between the share of government finances covered by numerical fiscal rules and budgetary outcomes 143

3.4.3. Relation between the characteristics and coverage of numerical fiscal rules and budgetary outcomes 146

3.4.4. Main conclusions from the study 149

4. National independent institutions 151

4.1. Introduction 151

4.2. Independent institutions can participate in different activities 151

4.2.1. Institutions operating in the field of ‘positive economics’ 151

4.2.2. Institutions operating in the field of ‘normative economics’ issue statements and recommendations on fiscal policy 152

4.3. Institutions in place in the EU 153

4.3.1. Institutions in charge of providing forecasts or / and conducting positive analysis on fiscal policy issues 154

4.3.2. Institutions in charge of issuing normative statements on the conduct of fiscal policies and recommendations 155

4.4. Link with budgetary outcomes and conclusions from the analysis of the questionnaires 160

4.4.1. Link with budgetary outcomes 160

4.4.2. General considerations inspired by the answers to the questionnaires 162

4.4.3. Main conclusions and findings from the study 163

Part IV: Fiscal policy in good times 171

1. Introduction 175

2. The cyclical behaviour of the fiscal stance 176

2.1. Introduction 176

2.2. Prescriptions from theory 176

2.3. Broad evidence 177

2.4. The recurrence of pro-cyclical fiscal policy: in search of explanations 180

3. The stance of fiscal policy in EU countries during good and bad times 182

3.1. Introduction 182

3.2. Defining good and bad times 182

3.2.1. In search of an operational definition 182

3.2.2. Measurement errors 184

3.3. The fiscal policy stance in good and bad times: a close look at the EU 187

3.3.1. Basic evidence 187

3.3.2. The cyclical behaviour of revenues and expenditures 189

3.3.3. Ex-ante vs. ex-post assessment of the cycle 192

3.4. Summary of findings 193

4. National rules and institutions to prevent pro-cyclical policies in good times 194

4.1. Introduction 194

4.2. Fiscal rules 194

4.2.1. Budget balance and debt rules 194

4.2.2. Expenditure rules 195

4.2.3. Revenue rules and rainy-day funds 196

4.3. National independent institutions 199

4.4. National fiscal rules and the stance of fiscal policy over the cycle 199

4.5. Summary of results 201

Part V: Member State developments 203

1. Belgium 205

2. The Czech Republic 210

3. Denmark 214

4. Germany 216

5. Estonia 221

6. Greece 223

7. Spain 226

8. France 230

9. Ireland 235

10. Italy 238

11. Cyprus 242

12. Latvia 245

13. Lithuania 247

14. Luxembourg 249

15. Hungary 251

16. Malta 254

17. Netherlands 257

18. Austria 259

19. Poland 262

20. Portugal 264

21. Slovenia 266

22. Slovakia 268

23. Finland 271

24. Sweden 273

25. United Kingdom 277

Part VI: Resources 283

1. Consolidated version of Council Regulation (EC) No. 1466/97 of 7 July 1997 285

2. Consolidated version of Council Regulation No. 1467/97 of 7 July 1997 294

3. Specifications on the implementation of the Stability and Growth Pact and Guidelines on the format and content of Stability and Convergence Programmes 304

4. Glossary 326

5. References 331

6. Useful Internet links 336

List of tables

Table I.1. General government budgetary position - Euro area. 2001-2006 (% of GDP) 28

Table I.2. Budget balances in EU Member States. 2004-2007 (% of GDP) 29

Table I.3. Composition of changes in government debt ratio in EU Member States. 2004-2007 (% of GDP) 30

Table I.4. Euro area government revenue and expenditure. 2003-2007 (% of GDP) 30

Table I.5. Total revenue and expenditure in EU Member States. 2004-2007 (% of GDP) 31

Table I.6. Overview of ongoing excessive deficit procedures 44

Table I.7. Country-specific MTOs 47

Table I.8. Projections of real growth in the 2005 updates (% change from the previous year) 48

Table I.9. Nominal budget balances in the 2005 updates and the Commission Autumn 2005 forecasts 49

Table I.10. Revenue and expenditure ratios in the 2005 updates 50

Table I.11. Euro area – Gross debt level and changes in the 2005 updates 51

Table I.12. Debt levels in the 2005 updates (as % of GDP) 52

Table I.13. Council examinations of the updated SCPs 2005 53

Table I.14: Parliamentary oversight of EU budgetary surveillance in the 25 Member States (number of cases) 55

Table I.15. Macro-economic assumptions according the national SCPs and the EPC projections 58

Table I.16. Change in the age-related budgetary items (between last year of the programme and 2050) 59

Table I.17. Results of the sustainability gap calculations 60

Table I.18. The structural primary balance and the Required Primary Balance 61

Table I.19. Gross government debt (% of GDP) 62

Table I.20. Overall classification of risks to sustainability 64

Table I.21. Are the overall policy conclusions different compared with last year’s assessment? 65

Table I.22. Policy conclusions by the Council on the sustainability of public finances 66

Table II.1. Main changes to the Stability and Growth Pact following the Council agreement of 20 March 2005 80

Table II.2. Data taken into account by Member States when setting their own medium-term budgetary objective 87

Table II.3. Data taken into account by the Council when deciding on the existence of an excessive deficit 96

Table II.4. 104(7) recommendations formulated in the past for EU-15 Member States 97

Table II.5. New and updated budgetary elasticities 108

Table II.6. New and updated budgetary sensitivities 109

Table II.7. The output gap series for the EU-25 Member States: synthetic indicators 110

Table II.8. Updated values of the minimal benchmarks for the 25 EU Member States 111

Table II.9. Projected changes in age-related public expenditure between 2004 and 2030/50 (% of GDP) 114

Table III.1. Properties of various ‘families’ of numerical fiscal rules with respect to different economic objectives 114

Table III.2. Target definitions by type of rule 114

Table III.3. Classification of numerical fiscal rules depending on the approach followed to centralise the budget process 114

Table III.4. Average change in budgetary variables following the introduction (or major changes) of fiscal rules in the EU-25 Member States (1990-2005) 114

Table III.5. Coverage of fiscal rules and develop-ments in the primary CAB (EU-25, 1990-2005) 114

Table III.6. Coverage of expenditure rules and developments in primary expenditure (EU-25, 1990-2005) 114

Table III.7. Influence of fiscal rules on the primary CAB (EU-25, 1990-2005) 114

Table III.8. Influence of expenditure rules on developments in primary expenditure (EU-25, 1990-2005) 114

Table III.9. List of institutions considered in the study 114

Table IV.1. Discretionary fiscal policy in good and bad times: evidence from econometric estimation of fiscal reaction functions 114

Table IV.2. Errors in assessing output gaps ex-ante. Absolute value of differences between ex-ante and ex-post output gaps. EU-11, 1995-2003 114

Table IV.3. Frequency of wrong ex-ante assessment of output gap sign. EU-11, 1995-2003 114

Table IV.4. Probability of a wrong real-time assessment of the output gap sign 114

Table IV.5: The fiscal stance over the cycle: evidence from the estimation of fiscal reaction functions: a) Cyclically-adjusted primary balance, b) Cyclically-adjusted revenues, c) Cyclically-adjusted primary expenditures, (EU11, 1980-2005) 114

Table V.1. Budgetary developments 2004-2009, Belgium (% of GDP) 114

Table V.2. Main measures in the budget for 2006, Belgium 114

Table V.3. Budgetary developments 2004-2008, The Czech Republic (% of GDP) 114

Table V.4. Main measures in the budget for 2006, The Czech Republic 114

Table V.5. Budgetary developments 2004-2010, Denmark (% of GDP) 114

Table V.6. Main measures in the budget for 2006, Denmark 114

Table V.7. Budgetary developments 2004-2009, Germany (% of GDP 114

Table V.8. Main measures in the budget for 2006, Germany 114

Table V.9. Agreements on expenditure growth for sub-sectors of government 114

Table V.10. Budgetary developments 2004-2009, Estonia (% of GDP) 114

Table V.11. Main measures in the budget for 2006, Estonia 114

Table V.12. Budgetary developments 2004-2008, Greece (% of GDP) 114

Table V.13. Main measures in the budget for 2006, Greece 114

Table V.14. Composition of the Greek foreign net lending/borrowing 114

Table V.15. Budgetary developments 2004-2008, Spain (% of GDP) 114

Table V.16. Main measures in the budget for 2006, Spain 114

Table V.17. Budgetary developments 2004-2009, France (% of GDP) 114

Table V.18. Main measures in the budget for 2006, France 114

Table V.19. Budgetary developments 2004-2007, Ireland (% of GDP) 114

Table V.20. Main measures in the budget for 2006, Ireland 114

Table V.21. Ireland – general government gross debt dynamics (average 2000-2004, in % of GDP) 114

Table V.22. Budgetary developments 2004-2009, Italy (% of GDP) 114

Table V.23. Main measures in the budget for 2006, Italy 114

Table V.24. Budgetary developments 2004-2009, Cyprus (% of GDP) 114

Table V.25. Main measures in the budget for 2006, Cyprus 114

Table V.26. Budgetary developments 2004-2009, Latvia (% of GDP) 114

Table V.27. Main measures in the budget for 2006, Latvia 114

Table V.28. Budgetary developments 2004-2008, Lithuania (% of GDP) 114

Table V.29. Main measures in the budget for 2006, Lithuania 114

Table V.30. Budgetary developments 2004-2008, Luxembourg (% of GDP) 114

Table V.31. Main measures in the budget for 2006, Luxembourg 114

Table V.32. Budgetary developments 2004-2008, Hungary (% of GDP) 114

Table V.33. Main measures in the budget for 2006, Hungary 114

Table V.34. Budgetary developments 2004-2008, Malta (% of GDP) 114

Table V.35. Main measures in the budget for 2006, Malta 114

Table V.36. Budgetary developments 2004-2008, The Netherlands (% of GDP) 114

Table V.37. Main measures in the budget for 2006, The Netherlands 114

Table V.38: Budgetary developments 2004-2008, Austria (% of GDP) 114

Table V.39. Main measures in the budget for 2006, Austria 114

Table V.40. Budgetary developments 2004-2008, Poland (% of GDP) 114

Table V.41. Main measures in the budget for 2006, Poland 114

Table V.42. Budgetary developments 2004-2009, Portugal (% of GDP) 114

Table V.43. Main measures in the budget for 2006, Portugal 114

Table V.44. Budgetary developments 2004-2007, Slovenia (% of GDP) 114

Table V.45. Main measures in the budget for 2006, Slovenia 114

Table V.46. Budgetary developments 2004-2008, Slovakia (% of GDP) 114

Table V.47. Main measures in the budget for 2006, Slovakia 114

Table V.48. Impact of the tax reform on public finance, preliminary results for 2004 114

Table V.49. Budgetary developments 2004-2009, Finland (% of GDP) 114

Table V.50. Main measures in the budget for 2006, Finland 114

Table V.51. Budgetary developments 2004-2008, Sweden (% of GDP 114

Table V.52. Main measures in the budget for 2006, Sweden 114

Table V.53. Convergence Programme (CP) plans versus outcomes (% of GDP). 114

Table V.54. Budgetary developments 2004/05-2010/11, United Kingdom (% of GDP) 114

Table V.55. Main measures in the 2005 Pre-Budget Report and the 2006 Budget, United Kingdom 114

List of graphs

Graph I.1. Euro-area fiscal stance and cyclical conditions. 2001-2007 32

Graph I.2. Euro-area policy-mix. 2001-2005 32

Graph I.3. Fiscal stance and cyclical conditions in the EU-25 Member States. 2005 33

Graph I.4. Policy-mix in the euro-area Member States. 2005 34

Graph I.5. Fiscal stance and cyclical conditions in the EU-15 Member States. 2006 34

Graph I.6. Budgetary plans, forecasts and outcomes in Germany 36

Graph I.7. Budgetary plans, forecasts and outcomes in France 36

Graph I.8. Budgetary plans, forecasts and outcomes in Portugal 37

Graph I.9. Budgetary plans, forecasts and outcomes in Greece 38

Graph I.10. Budgetary plans, forecasts and outcomes in the Netherlands 38

Graph I.11. Budgetary plans, forecasts and outcomes in the Italy 39

Graph I.12. Budgetary plans, forecasts and outcomes in the UK 39

Graph I.13. Budgetary plans, forecasts and outcomes in Hungary 40

Graph I.14. Budgetary plans, forecasts and outcomes in Czech Republic 40

Graph I.15. Budgetary plans, forecasts and outcomes in Cyprus 41

Graph I.16. Budgetary plans, forecasts and outcomes in Malta 41

Graph I.17. Budgetary plans, forecasts and outcomes in Poland 41

Graph I.18. Budgetary plans, forecasts and outcomes in Slovakia 42

Graph I.19. Nominal budget balances in the euro area: evolution in projections from the 2000 - 2005 updates of the stability programmes (% of GDP) 48

Graph I.20. Contributions to change in budgetary position 2005-2008 (in percentage points) 50

Graph I.21. Debt to GDP ratio in the euro area: evolution in projections from the 2000 updates to the 2005 updates of the stability programmes (% of GDP) 51

Graph I.22. Debt development in EU 63

Graph II.1. MTOs and debt levels 88

Graph II.2. MTOs and potential growth prospects 88

Graph II.3. The adjustment path towards the medium-term objectives projected by Member States in the 2005 updated Stability and Convergence Programmes 92

Graph II.4. More cautious macroeconomic assumptions 92

Graph II.5. One-off and temporary measures implemented in 2005 and projected by Member States for the period 2006-2008 93

Graph II.6. Forecast annual change in the structural balance – Spring 2006 Commission forecasts 93

Graph II.7. Medium-term budgetary plans of Member States in EDP (simple averages) 98

Graph II.8. The adjustment path towards the medium-term objectives 98

Graph II.9. One-off and temporary measures in the euro area, as a % of GDP 102

Graph II.10. More and bigger one-offs when the deficit is close to 3% (1993-2005, euro area countries) 102

Graph II.11. Why Portugal did not get out of trouble 103

Graph II.12. Minimal benchmarks: an illustration 109

Graph II.13. Age pyramids for EU25 population 114

Graph II.14. Potential growth rates and their determinants (employment/productivity) 114

Graph II.15. The cost of delay in implementing a fiscal adjustment 114

Graph III.1. Developments in the debt ratio in the main industrialised regions since 1970 114

Graph III.2. Developments in the debt ratio in the main industrialised countries and in the EU over the last 30 years 114

Graph III.3. Number of numerical fiscal rules in force in the EU Member States 114

Graph III.4. Number of numerical fiscal rules by sub-sector of general government 114

Graph III.5. Time horizon of fiscal rules by sub-sector of general government 114

Graph III.6. Statutory base of fiscal rules by sub-sector of general government 114

Graph III.7. Enforcement mechanisms of numerical fiscal rules by sub-sector of general government 114

Graph III.8. Media activity and numerical fiscal rules in different sub-sector of general government 114

Graph III.9. ' Fiscal rule coverage index' and 'Expenditure rule coverage index' – EU-25 (unweighted average) 114

Graph III.10. Fiscal rule coverage index and average primary CABs in the EU-25 countries 114

Graph III.11. Index of strength of the fiscal rules in force in EU Member States in 2005 (classified according to the average value) 114

Graph III.12. Shortfall in real GDP growth and in the General government balance 114

Graph III.13. Perception of respondents on the visibility of the analysis made by independent institutions 114

Graph III.14. Perception of respondents on the quality of the analysis made by independent institutions and their impact on fiscal discipline 114

Graph III.15. Budgetary developments in countries with and without independent institutions (1995-2005) 114

Graph IV.1. Fiscal Stance (change in CAPB, GDP) measured against the output gap; euro area 114

Graph IV.2. Distinguishing phases of the economic cycle on the basis of output gap changes and levels 114

Graph IV.3. Correlation interest expenditure ratio and CAPBs 114

Graph IV.4. Fiscal stance and output gap. A basic scatterplot (EU11, 1980-2005) 114

Graph IV.5. Fiscal stance in good and bad times (EU-25, EU-11, EU-10, 1980-2005) 114

Graph IV.6. Frequency of episodes of pro and counter-cyclical in good and bad times (EU25, EU11, EU10) 114

Graph IV.7. Fiscal stance in good and bad times (EU11, 1980-2005, different sub-periods) 114

Graph IV.8. Frequency of episodes of pro and counter-cyclical in good and bad times (EU11, 1980-2005) 114

Graph IV.9. Change in the primary cyclically-adjusted budget balances and its components in good and bad times (EU11, 1980-2005) 114

Graph IV.10. Change in the primary cyclically-adjusted budget balances and its components in upturns and downturns (EU11, 1980-2005) 114

Graph IV.11. Fiscal stance and the cycle measured ex-post and in real time (EU11, 1995-2003) 114

Graph IV.12. Frequency of episodes of pro and counter-cyclical behaviour of fiscal policy. Real-time and ex-post output gap estimation (22 EU countries, 1990-2005) 114

Graph IV.13. Fiscal stance in correspondence with different levels of the output gap (EU11, 1980-2005) 114

Graph IV.14: Fiscal rules and stabilisation: questionnaire replies 114

Graph IV.15. Frequency of episodes of pro and counter-cyclical fiscal policy. Weak and strong fiscal rule countries (22 EU countries, 1990-2005) 114

Graph IV.16. Frequency of episodes of pro and counter-cyclical behaviour of government expenditure. Weak and strong expenditure rule countries (22 EU countries, 1990-2005) 114

Graph V.1. Government expenditure as % of GDP 114

Graph V.2. Revenue sources for regions and communities in 2005 114

Graph V.3. Composition of the Greek foreign net lending/borrowing 114

Graph V.4. Evolution of regional expenditure (% of GDP and % of Total government expenditure) 114

Graph V.5. Deficit and debt of regional governments (in % of GDP 114

Graph V.6. Regional government expenditure in health care and education (in % of GDP) 114

Graph V.7. Central government expenditure (% nominal change) 114

Graph V.8. Social security funds' expenditure (% nominal change) 114

Graph V.9. Local government expenditure (% nominal change) 114

Graph V.10. Ireland - general government debt net of the NPRF's assets (in % of GDP) 114

Graph V.11. Malta – Privatisation proceeds and debt (Million MTL) 114

Graph V.12. Indicative Index of Productivity 1995-2002, 1995=100 114

Graph V.13. NHS Output, 1999=100 114

List of Boxes

Box I.1. The enforcement mechanisms of the Stability and Growth Pact 42

Box I.2. Making the SGP reform take root: an increasing role for national institutions, including Parliament 55

Box II.1. Regulations 1466/97 and 1467/97 have different legal basis and followed different revision procedures 77

Box II.2. The treatment of systemic pension reforms in the excessive deficit procedure 83

Box II.3. Budgetary sensitivities: definition and construction 106

Box II.4. Alternative methods for computing minimal benchmarks 112

Box III.1. Procedural rules of the budget process and budgetary outcomes 114

Box III.2. Is there a case for delegating part of fiscal policy to independent institutions? 114

Box III.3. The questionnaire on numerical fiscal rules 114

Box III.4. Construction of a time-varying 'Fiscal rule coverage index' and a time-varying 'Expenditure rule coverage index' 114

Box III.5. Calculation of an index of strength of fiscal rules 114

Box III.6. The questionnaire on fiscal institutions or councils 114

Box III.7. The Belgian National Account Institute (NAI) 114

Box III.8. The Netherlands Bureau for Economic Policy Analysis (CPB) 114

Box III.9. Other institutions 114

Box IV.1. Interest rate developments and the fiscal stance. Are "interest rate good times" coming to an end? 114

Box IV.2. Revenue rules to prevent pro-cyclical fiscal policy in good times in EU countries 114

Box IV.3: Rainy-day funds and their operation 114

Abbreviations and symbols used

Member States

BE Belgium

CZ Czech Republic

DK Denmark

DE Germany

EE Estonia

EL Greece

ES Spain

FR France

IE Ireland

IT Italy

CY Cyprus

LV Latvia

LT Lithuania

LU Luxembourg

HU Hungary

MT Malta

NL The Netherlands

AT Austria

PL Poland

PT Portugal

SI Slovenia

SK Slovak Republic

FI Finland

SE Sweden

UK United Kingdom

EUR-12 European Union Member States having adopted the single currency (BE, DE, EL, ES, FR, IE, IT, LU, NL, AU, PT, FI), i.e. countries participating in the economic and monetary union without a derogation

EU-25 European Union, 25 Member States

EU-15 European Union, 15 Member States before 1. May 2004 (EUR-12 plus DK, SE and UK)

EU-10 European Union, 10 Member States that joined the EU on 1. May 2004 (CZ, EE, CY, LV, LH, HU, MT, PL, SI, SK)

Currencies

EUR euro

ECU European currency unit

DKK Danish krone

GBP Pound sterling

SEK Swedish krona

CAD Canadian dollar

CHF Swiss franc

JPY Japanese yen

SUR Russian rouble

USD US dollar

Other

SCP Stability and Convergence Programmes

PEP Pre-accession Economic Programmes

Executive summary

Recent budgetary developments and prospects

In 2005, the budgetary position in the euro area and the EU improved significantly. In the euro area, the government deficit fell by 0.4 percentage point and reached 2.4 percent of GDP. The deficit of the entire EU also improved by 0.3 percentage points and reached 2.3 percent of GDP in 2005. The deficit reduction in the euro area and in the EU reflects better-than-expected economic growth, better than expected revenues, as well as structural budgetary adjustment. It was particularly important in the countries currently subject to an excessive deficit procedure (EDP). According to the spring 2006 forecasts of the Commission services, the euro area and EU deficits would remain roughly stable in 2006 and 2007, based on the assumption of unchanged policy. After increasing in 2005 for a second consecutive year, the debt-to-GDP ratio in the EU would fall from 63.4 percent in 2005 to 62.9 percent in 2006.

Since spring 2005, the Commission and the Council took action on six Member States currently subject to an EDP. The Commission and the Council considered that the Netherlands had corrected its excessive deficit and the Council decided to abrogate the EDP for this country in June 2005. In June 2005 the Council also adopted a decision that an excessive deficit exists in Italy and set fiscal efforts and deadlines for its correction in a recommendation under Article 104(7) of the Treaty. The same actions were taken in September 2005 for Portugal and in January 2006 for the UK. In light of the fiscal notifications of spring 2006, the Council decided in March 2006 to address a notice in accordance with Article 104(9) to Germany, which has to correct its excessive deficit in 2007. Finally, the Commission and the Council considered that Hungary has not respected the recommendations formulated in the 104(7) recommendation. Since January 2006, twelve EU countries are subject to an excessive deficit procedure: five euro-area Member States, the UK and six new Member States.

In the context of budgetary surveillance, the Commission also assessed the 2005 updates of the stability and convergence programmes submitted by Member States and proposed Council Opinions on these documents. In these programmes, the nominal deficit in the EU and in the euro area is projected to be reduced from 2.5 percent of GDP in 2005, to 1.4 percent of GDP in 2008. The improvement relies notably on the large budgetary consolidation projected in the Member States in EDP. According to the calculations of the Commission based on the figures of the programmes, the cyclically-adjusted budget balance (CAB) would improve in the euro area and in the EU from -2.1 percent of GDP in 2005 to -1.0 percent of GDP in 2008. In 2006 is planned only a minor improvement in the CAB, while significant structural efforts are envisaged for 2007 and 2008. Most Member States revised their debt level upwards but project a gradual improvement over the programme period.

The EU faces a major budgetary challenge in view of ageing populations over the coming decades. The assessment of this round of Stability and Convergence Programmes suggests that the increased focus on the long-term sustainability of public finances in the EU – reinforced by Ministers in the context of the reform of the Stability and Growth Pact – has contributed to incorporate longer-term concerns in the policy-making processes. The analysis of the 2005/06 updates of the stability and convergence programmes reveals that six Member States (the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia), face a high risk with regard to the long-term sustainability of public finances in view of the budgetary impact of ageing populations. Ten Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, the Netherlands and the UK) are at medium risk and the remaining nine countries (Denmark, Estonia, Latvia, Lithuania, Austria, Poland, Slovakia, Finland and Sweden) are at low risk. For a large majority of countries, achieving the planned budgetary consolidation over the medium-term would contribute substantially to reduce the sustainability challenge. However, for a number of countries structural reforms in particular in the field of pensions need to complement the budgetary efforts to ensure a sustainable fiscal position in the long term.

The EU fiscal framework one year after the reform of the Stability and growth Pact

One year ago, the EU heads of State or Government endorsed the March 2005 ECOFIN Council report containing the main directions for reforming the Stability and Growth Pact. Since then, the revised SGP has been codified in regulations. Where necessary, further clarifications on how to interpret the new text of the Regulations were included in a revised Code of Conduct for the implementation of the Stability and Growth Pact. This is the case for several provisions regarding the preventive arm of the SGP, notably the modalities for the determination of the medium-term budgetary objectives (MTOs) and the criteria for the assessment of the adjustment path towards the MTOs. Section II of the report summarises the result of one year of work to codify and make operational the revised SGP. It also provides a first review of the implementation of the revised SGP.

The 2005 SGP reform introduced new concepts, definitions and principles in the preventive arm of the SGP. In order to ensure a consistent application of the rules, a number of elements were specified since spring 2005. Notably, the methodology for setting the country-specific medium-term budgetary objectives (MTOs) was clarified and, in parallel, the Commission has started work on how implicit liabilities could in future be taken into account in their determination. A number of issues related to the definition of the adjustment path towards the MTOs were also clarified, including the conditions for taking into account structural reforms in the preventive arm of the SGP.

The Commission assessment of the functioning of the preventive arm of the pact is mixed. On the positive side, differentiated medium-term budgetary objectives reflecting country-specific economic fundamentals were set in the context of the 2005 updated Stability and Convergence Programmes. In addition, Member States lived up to their commitment to base their budgetary projections on realistic macroeconomic assumptions, and the recourse to one-off measures has clearly declined. The Commission assessment of the 2005 updated stability and Convergence Programmes also pointed to some deviations from the agreed principles. Notably, the structural fiscal adjustment planned for 2006 by Member States not yet at their MTO falls short of the 0.5 percent benchmark agreed at the moment of the reform. This provides evidence that the benign economic environment is not being exploited to progress towards the MTO. In addition, in some Member States, the projected adjustment is back-loaded and not underpinned by concrete measures.

The experience with the implementation of the excessive deficit procedure is positive. the Commission reports initiating the excessive deficit procedure gave consideration to all elements that appeared relevant for an evaluation of the situation when deciding on the existence of an excessive deficit and when setting the deadline for its correction. The increased room for judgement has notably been applied to set realistic deadlines for Member States to correct their excessive deficits, while ensuring that significant fiscal efforts are made. The application of the provisions related to 'other relevant factors' in the steps leading to a decision on the existence of an excessive deficit confirmed that the SGP remains a rules-based framework: since the reform, all deficits in excess of 3 percent of GDP have been considered excessive. Finally, the SGP reform stimulated a constructive and transparent policy dialogue on the individual country cases at EU level, which contributed to a smooth and efficient operation of the Pact.

By moving the emphasis from a single indicator to a more reasoned analysis of budgetary positions, the reform of the Stability and Growth Pact has reinforced the need to strengthen the knowledge and understanding of budgetary developments in each Member State. In the past twelve months, progress was notably made on issues related to the measurement of budgetary positions and policies. The concept of one-off and temporary measures was specified and clear principles have been agreed for taking into account such measures in the context of budgetary surveillance. Progress was also made on the cyclical adjustment of budget deficits: budget sensitivities to the cycle were updated for all Member States which allowed estimating a new set of values for the country-specific minimal benchmarks. Over the last months, several developments have contributed to improving the quality of budgetary statistics: the Council amended the regulation governing the transmission of fiscal data by Member States in order to increase the operational capacity of Eurostat in assessing the quality of government statistics and to improve transparency in the data compilation and notification procedure. Following discussions on standards for the institutional set-up of national and Community statistical authorities, on 25 May 2005 the Commission recommended that Member States recognise the European Statistics Code of Practice as a common set of standards for statistical authorities in the EU.

The quantification of the implications for government finances of population ageing has been improved. Long-term budgetary projections were updated on the basis of commonly agreed assumptions and methods for a wide range of budgetary items (pensions, health-care, long-term care, education and unemployment benefits). With regard to the analysis of public finance sustainability in the context of the assessment of the annual updates of stability and convergence programmes, some improvements were introduced in the latest assessment round. A decomposition of the sustainability indicators has been introduced, which examines whether risks to public finance sustainability mainly come from the short-term or long-term budgetary developments. Second, a new sensitivity test has been introduced, which shows the additional budgetary cost that arises from a delayed adjustment.

Analytical sections

The role of national budgetary rules and institutions in promoting sound public finances

The debate on the ways to improve fiscal policies has recently focused on the need to rebalance the incentives of policy-makers or impose constraints on the conduct of fiscal policy via the introduction of adequate fiscal rules and institutions at national level. At EU level, the Maastricht Treaty and the Stability and Growth Pact (SGP) impose budgetary obligations on Member States. In order to ensure the respect of objectives, both of them also stress the importance of national institutions for budgetary discipline. In particular, the report on the SGP reform endorsed by the European Council on 22 March 2005 states that 'national budgetary rules should be complementary to the Member States’ commitments under the Stability and Growth Pact' and that 'national institutions could play a more prominent role in budgetary surveillance'. Section III of the report focuses on national numerical fiscal rules and independent institutions which may influence fiscal policy making. It exploits the results of surveys which review the rules and institutions in force in the 25 EU Member States in the period 1990-2005 and assesses whether these arrangements have an effect on budgetary outcomes.

It comes out from the analysis of the survey on numerical fiscal rules that the number of rules in force in EU Member States has increased continuously over the past twenty years. The characteristics of the numerical fiscal rules in place vary depending on the sub-sector to which they apply. While most of the rules applied to regional and local governments are enshrined in a legal text, rules applying to the whole of the general government sector are more frequently based on political agreements and commitments. Similarly, while rules for regional and local governments seem to have relatively strong enforcement procedures, rules applying to general and central governments generally do not envisage ex ante defined actions in case of non compliance. Statistical and econometric exercises suggest the existence of a link between numerical rules and budgetary outcomes. The analysis takes into account the coverage and characteristics of fiscal rules and controls for various factors that may affect government budget balance and developments in primary expenditure. It appears that an increase in the share of government finances covered by numerical fiscal rules leads, ceteris paribus, to lower deficits. In the case of expenditure rules, it appears that an increase in the coverage of government finances by expenditure rules leads to a reduction in the primary expenditure-to-GDP ratio. The analysis also suggests that the characteristics of fiscal rules matter for their influence on budgetary outcomes. Strong rules, enshrined in law or constitution and foreseeing automatic enforcement mechanisms, seem to have a larger influence on budgetary outcomes.

The survey on national fiscal institutions shows that, contrasting with the conclusion reached for fiscal rules, there is no visible tendency towards the development of 'fiscal councils' in the EU Member States. There is a large variety in the type of institutions in place. Two major categories are distinguished: (i) institutions in charge of providing forecasts or/and conducting positive analyses on fiscal policy issues; and (ii) institutions issuing normative statements and recommendations on the conduct of fiscal policy. Assessing the influence of the institutions covered by the study on fiscal policy is by nature difficult. However, combining descriptive analysis, the result of existing studies on the subject and the answers from the questionnaires, a number of tentative conclusions on the contribution of such institutions to fiscal discipline are drawn in the report. First, delegation of the forecasting activity seems to be an efficient way to address possible optimistic biases in macroeconomic projections. Second, the institutions in place seem to have a considerable impact on the public debate and the recommendations formulated are generally followed by governments. Finally, there is a general perception that independent fiscal institutions have contributed to fiscal discipline.

Fiscal policy in good times

In spite of the unanimous view among economists and policy makers that pro-cyclical fiscal policies should be avoided, counter-cyclical fiscal policies are far from being the norm in most countries. What is most surprising is that the available evidence seems to indicate that in most advanced countries pro-cyclicality is an issue that mostly arises in good times, when the economic activity is above potential or when growth is above trend. This is somehow puzzling, since while in bad times a trade-off could emerge between the objective of output stabilisation and that of budgetary discipline, the two objectives go hand in hand in good times. The direct consequence of a pro-cyclical behaviour of fiscal policy is an unnecessary amplification of GDP fluctuations. Furthermore, the prevalence of pro-cyclical behaviour in good times is responsible for a considerable share of debt growth in EU countries.

The analysis carried out in this years' Report reveals that episodes of pro-cyclical fiscal policy were frequent in euro-area countries in the past decades. The picture, however, is quite different depending on the period considered. While during the run-up to EMU pro-cyclicality took place mostly during bad times, after the completion of EMU budgetary corrections in bad times became less common, but there was a greater incidence of pro-cyclical policies in good times. The separate analysis of government revenues and expenditures reveals that the pro-cyclical bias is mainly related with the behaviour of expenditures, which appear to grow faster in periods of positive output gap. An explanation could be identification and implementation lags. Strong pressures to spend budgetary windfalls accruing in good times would be an aggravating factor. The analysis also shows that, although revisions in output gap estimates can be quite considerable, errors in measuring the cycle in real time can explain to some extent pro-cyclicality in bad times, but the same does not hold for pro-cyclical behaviour in good times.

A possible response to the pro-cyclical bias of fiscal policy is setting up national-level rules and institutions that permit governments to credibly commit not to surrender to the pressures to increase spending or cut taxes in good times. Expenditure frameworks aimed at capping the growth of expenditure over a medium-term framework can address the tendency for expenditure to grow faster in good times. Revenue rules that determine ex-ante which share of revenue windfalls will be saved or the establishment of rainy-day funds can strengthen the commitment of governments not to spend or give away via tax cuts better than expected budgetary outcomes materialising in good times. "Fiscal councils" providing technical inputs in fiscal policy-making, including via high-quality independent macroeconomic forecasts and a thorough estimation of the budgetary impact of policy measures could permit a better working of the rules aimed at addressing the pro-cyclical bias. The analysis in the report supports the view that expenditure rules could be an effective instrument to curb the pro-cyclical bias. It is shown that the countries endowed with effective expenditure frameworks have been less inclined to run pro-cyclical expenditure policies in good times.

An institutional framework for budgetary policy at national level that strengthens the ability of governments to keep budgets under control in strong phases of the cycle would be consistent with the reformed Stability and Growth Pact, which puts enhanced emphasis on the need for countries to step up adjustment efforts in good times to achieve their medium-term budgetary objectives. Efforts to make progress on this front should not be delayed. There is mounting evidence that good times are going to be there again. Growth in the euro area is recovering and output may return above potential in a majority of countries in the near future. Member States need to avoid the mistakes of the past and be ready to make the best use of such an opportunity to combine an appropriate use of fiscal policy as a stabilisation tool with progresses towards achieving their medium-term budgetary objectives.

Part I

Current developments and prospects

Summary

In 2005, the budgetary position in the euro area and the EU improved quite significantly. In the euro area, the nominal deficit fell by 0.4 percentage point and reached 2.4 percent of GDP. The aggregate nominal deficit of the entire EU also improved by 0.3 percentage points and reached 2.3 percent of GDP in 2005. Such a relatively good budgetary performance is due to better than expected growth performance, higher than expected revenues, as well as structural budgetary adjustment. In cyclically-adjusted terms, relative to 2004, the deficit in the euro area was reduced substantially to 1.9 percent of GDP, an improvement of 0.7 percentage points. The improvement in the budgetary position was particularly important in the countries currently subject to an excessive deficit procedure. Germany, Greece and France substantially reduced their deficits. However, fiscal imbalances increased in Italy and Portugal. Outside the euro area, apart from Hungary and the UK, all the EDP countries improved their budget balances, with Cyprus and Poland bringing their budget deficits below the reference value.

According to the Spring 2006 forecasts of the Commission services, the euro-area and EU deficits would remain roughly stable in 2006 and 2007, based on the assumption of unchanged policy. Projected developments in the EU and euro-area deficits result from diverse budgetary performances across Member States. In 2006, the deficit is projected to reach 3 percent of GDP in France, Poland and the UK, while in Germany and the Czech Republic it is expected to be just above the reference value. The deficit would be brought below 3 percent in 2006 in Malta and Slovakia is expected to further consolidate it below this value. On the other hand, deficits in Italy, Portugal and Hungary are expected to remain significant. Among the euro-area countries with high cyclically-adjusted deficits, structural improvements over the entire projection period are expected only in Germany and Portugal. Outside the euro area, most of the countries are foreseen to see a worsening or no changes in the cyclically adjusted deficit. The most significant worsening are expected in Hungary, Czech Republic and Poland. The only countries for which improvements over the forecast period are foreseen are Cyprus, Latvia, Slovakia and the UK. Larger efforts to improve the structural budget positions would be expected as recent indicators confirm the improvement in economic conditions. This would allow to ensure sufficient room for the automatic stabilisers to operate when necessary.

The debt-GDP ratio in the euro area and the EU has increased for the second consecutive year in 2005. However, as a consequence of the positive performance of the underlying fiscal position, the dynamics in the debt-to-GDP ratio are projected to improve. The euro-area debt ratio is projected to fall from 71.7 percent in 2005 to 70.5 percent in 2006 and 70.1 percent in 2007. In the EU, the debt-to-GDP ratio would fall from 63.4 percent in 2005 to 63.2 percent in 2006. The debt ratio would remain particularly high in Belgium, Greece, and in Italy. In the latter, the debt ratio would continue increasing over the projection period. The debt ratio is also projected to increase over the next two years from a relatively high level in Germany, France and Portugal.

Since spring 2005, the Commission and the Council took action on six Member States currently subject to an Excessive Deficit Procedure (EDP). The Commission and the Council considered that the Netherlands had corrected its excessive deficit and the Council decided to abrogate the excessive deficit procedure for this country in June 2005. In June 2005 the Council also adopted a decision that an excessive deficit exists in Italy and set fiscal efforts and deadlines for the correction of the excessive deficit in a recommendation under Article 104(7) of the Treaty. The same decisions and recommendations were adopted in September 2005 for Portugal and in January 2006 for the UK. In light of the fiscal notifications of Spring 2006, the Council decided in March 2006 to address a notice in accordance with Article 104(9) to Germany, which has to correct its excessive deficit in 2007. Finally, the Commission and the Council considered that Hungary has not respected the recommendations formulated in the 104(7) recommendation. Since January 2006, twelve EU countries are subject to an excessive deficit procedure: five euro-area Member States, the UK and six new Member States.

In the context of budgetary surveillance, the Commission also assessed the 2005 updates of the stability and convergence programmes submitted by all the Member States and proposed Council opinions on these documents. The macroeconomic assumptions underlying the medium-term budgetary projections have on average been considered realistic, which is a major progress compared to previous updates. Regarding budgetary plans, the nominal deficit in the EU and in the euro area is projected to be reduced from 2.5 percent of GDP in 2005, to 1.4 percent of GDP in 2008. The improvement relies notably on the large budgetary consolidation projected in the Member States in EDP. According to the calculations of the Commission based on the figures of the programmes, the cyclically-adjusted budget balance (CAB) would improve in the euro area and in the EU from -2.1 percent of GDP in 2005 to -1.0 percent of GDP in 2008. In 2006 is planned only a minor improvement in the CAB, while significant structural efforts are backloaded to 2007 and 2008, but policy measures are often unspecified. Most Member States revised their debt level upwards but project a gradual improvement in the debt ratio over the programme period. Apart from the Czech Republic, Poland, Slovenia, Slovakia and the UK, all non-euro-area Member States are expected to have lower debt levels in 2008 than in 2005. By the end of the programme period, only in Malta government debt is expected to stay above the 60 percent of GDP reference value.

The EU faces a major budgetary challenge in view of ageing populations over the coming decades. The assessment of this round of Stability and Convergence Programmes suggests that the increased focus on the long-term sustainability of public finances in the EU – reinforced by Ministers in the context of the reform of the Stability and Growth Pact – has contributed to incorporate longer-term concerns in the policy-making processes. The analysis of the 2005/06 updates of the stability and convergence programmes reveals that six Member States (the Czech Republic, Greece, Cyprus, Hungary, Portugal and Slovenia), face a high risk with regard to the long-term sustainability of public finances in view of the budgetary impact of ageing populations. Ten Member States (Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, Malta, the Netherlands and the UK) are at medium risk and the remaining nine countries (Denmark, Estonia, Latvia, Lithuania, Austria, Poland, Slovakia, Finland and Sweden) are at low risk.

For a large majority of countries, achieving the planned budgetary consolidation over the medium-term as envisaged in the programmes would contribute substantially to reduce the sustainability challenge. However, for a number of countries structural reforms in particular in the field of pensions need to complement the budgetary efforts to ensure a sustainable fiscal position in the long term.

2. Budgetary developments in the euro area and EU Member States

3. Short-term developments and prospects for the budget balance and public debt

In 2005, the budgetary position in the euro area improved significantly after a slight improvement in 2004 following deterioration in period 2001-2003 (see Table I.1). Compared to 2004, the nominal deficit fell by 0.4 percentage point and reached 2.4 percent of GDP. The aggregate nominal deficit of the entire EU also improved by 0.3 percentage points and reached 2.3 percent of GDP in 2005 (see Table I.2).

The aggregate outcome for the euro area as a whole results from diverse budgetary performances across Member States. In the case of Germany, France, Greece, Italy and Portugal the budgetary positions in 2005 remained weak with nominal deficits ranging from 2.9 percent of GDP in France to 6 percent of GDP in Portugal. It is, however, important to stress substantial improvement in budget balances of Greece (of 2.4 percentage points), France (0.8 percentage points) and Germany (0.4 percentage points). On the other hand budgetary situation worsened in Italy and Portugal by respectively 0.7 and 2.8 percentage points. Among the countries mentioned above, only France succeeded in bringing its deficit below the 3 percent of GDP reference value in 2005. In 2005 the nominal deficit has significantly improved in Spain and the Netherlands, respectively, by 1.2 and 1.6 percentage point. Given the improved growth conditions in 2005, the Netherlands joined the group of countries that had nominal budget positions in balance or in surplus in 2004 (in 2005 – Belgium, Ireland, Spain, the Netherlands and Finland; in 2004, only Belgium, Ireland and Finland and Spain). Overall, the nominal budget balances in 2005 worsened compared to the previous year only in the case of Ireland, Italy, Luxembourg, Austria and Portugal.

Certainly, the budgetary performance also differed across the Member States outside the euro area. Relative to 2004, the budget position remained roughly unchanged or improved in a large majority of Member States with exception of Hungary and the UK, where deficits widened further. Nominal budget balances in 2005 varied from a deficit of 6.1 percent of GDP in Hungary to a surplus of 4.9 percent of GDP in Denmark. Only in the case of Hungary, Malta and the UK, the nominal deficit in 2005 was above the reference value of 3 percent of GDP while a number of countries reached a surplus budgetary position (Denmark, Estonia, Latvia and Sweden). The improvement was particularly important in Denmark, Cyprus, Malta and Poland.

Looking ahead to 2006 and 2007, the Commission Spring 2006 forecasts project that economic growth in the euro area as a whole will hover around 2 percent reaching 2.1 percent in 2006 and decline temporarily to 1.8 percent in 2007. The nominal budget balance is expected to stay at 2.4 percent of GDP in 2006 and improve slightly in 2007 (2.3 percent of GDP). Despite the improving economic situation, given the difficulties in pursuing budgetary consolidation, the aggregate nominal deficit for the entire EU is foreseen to hold stable at 2.3 percent of GDP in 2006 and decline only slightly to 2.2 percent of GDP in 2007.

At the Member State level, the surplus budgetary position in the case of Belgium is expected to deteriorate into a deficit position in 2006, while the surplus in Ireland is expected to be significantly reduced. Under a no-policy-change assumption, the deficits in both countries would continue to worsen in 2007. In contrast, Spain and Finland are expected to maintain their budgetary positions in surplus throughout the forecast period. Among the Member States outside the euro area, this is also the case of Denmark, Estonia and Sweden.

On the basis of current policies, the Commission forecast projects that the nominal deficits in Germany, Italy and Portugal will be exceeding the 3 percent of GDP reference value in 2006 while Greece is expected to reach the 3 percent of GDP reference value. While the German deficit will improve and be just above the 3 percent reference value and an improvement is expected also for the Portuguese deficit (which remain however at 5 percent of GDP), no improvement is expected for the Italian deficit. According to the Commission forecast, the budgetary situation is expected to slightly worsen in France as a deficit of 3 percent of GDP is projected. In 2007, apart from Germany all the abovementioned countries are expected to stay above the 3 percent of GDP reference value or to breach it again. In Germany, the nominal deficit is projected to remain above 3 percent of GDP in 2006 and move below the reference value in 2007. In Greece, the nominal deficit is expected to be at 3 percent of GDP in 2006 and worsen again in 2007. Although the excessive deficit procedure for Portugal was abrogated in 2004, the nominal deficit is foreseen to exceed 3 percent of GDP again in both 2005 and 2006. In Italy, although the nominal deficit is projected beyond the threshold in 2005 and will deteriorate further in 2006.

The nominal deficit is projected to stay above the reference value also in some other Member States. Despite an already very high deficit, budgetary situation in Hungary is projected to worsen in 2006 and 2007, when it is expected to reach 7 percent of GDP. Following good budgetary performance in 2005, deficit in the Czech Republic is expected to be above the reference value throughout the forecast period, while for Poland, it is expected to stay at 3 percent of GDP. In Malta, after a solid consolidation below the reference value expected for 2006, the deficit is expected to be above 3 percent of GDP again in 2007. In the UK, it is foreseen to be at 3 percent of GDP in 2006 and decline below the deficit reference value in 2007. In 2006, most of the new member states expect the nominal deficit increase slightly or to remain unchanged. In the case of Latvia, a significant deterioration is projected for 2006, while the surplus in Estonia is expected to be reduced over the forecast period.

In cyclically-adjusted terms, relative to 2004, the deficit in the euro area was reduced substantially to 1.9 percent of GDP, an improvement of 0.7 percentage points. According to the Commission Spring 2006 forecasts, the cyclically adjusted budget balance is projected to increase slightly in 2006 and improve again slightly in 2007. Among the euro-area countries with higher cyclically-adjusted deficits, improvements over the entire projection period are expected only in Germany and Portugal. In Greece a significant improvement is expected in 2006, however for 2007, the cyclically-adjusted deficit should be higher again. In Italy, no improvement is foreseen in 2006 and for 2007, a widening of the cyclically-adjusted deficit is projected. No change over the forecast period is foreseen for France, the cyclically-adjusted deficit is expected to stay at 2.5 percent of GDP.

Outside the euro area, most of the countries are foreseen to see a worsening or no changes in the cyclically adjusted deficit. The most significant deteriorations are expected in Hungary, Czech Republic and Poland, where the deficits are foreseen to reach respectively 7.1 percent, 4 percent and 3.5 percent of GDP in 2007. The only countries for which improvements over the forecast period are foreseen are Cyprus, Latvia, Slovakia and the UK.

Table I.1. General government budgetary position - Euro area. 2001-2006 (% of GDP)

2002(1) | 2003 | 2004 | 2005 | 2006 | 2007 |

Total revenue (1) | 45.1 | 45.1 | 44.7 | 45.1 | 45.0 | 44.8 |

Note: differences are due to rounding.

(1) Including UMTS receipts. UMTS receipts as a percent of GDP would be equal in 2002 to 0.2 for IE and 0 for the euro area and EU-15.

Source: Commission Spring 2006 forecasts . .

Table I.2. Budget balances in EU Member States. 2004-2007 (% of GDP)

Budget balance | Cyclically-adjusted budget balance | Cyclically-adjusted primary balance |

Total revenue | 45,1 | 44,7 | 45,1 | 45,0 | 44,8 |

- Cyclically-adjusted | 45,3 | 44,9 | 45,5 | 45,4 | 45,2 |

Taxes on imports and production | 13,1 | 13,3 | 13,4 | 13,5 | 13,8 |

Current taxes on income and wealth | 11,5 | 11,4 | 11,6 | 11,6 | 11,4 |

Social contributions | 15,8 | 15,6 | 15,6 | 15,6 | 15,3 |

of which actual social contributions | 14,7 | 14,5 | 14,4 | 14,4 | 14,2 |

Other revenue | 4,7 | 4,5 | 4,5 | 4,4 | 4,3 |

Total expenditure | 48,1 | 47,5 | 47,5 | 47,4 | 47,1 |

- Cyclically-adjusted | 48,1 | 47,4 | 47,4 | 47,3 | 47,1 |

Collective consumption | 8,1 | 8,0 | 8,0 | 7,9 | 7,9 |

Social benefits in kind | 12,3 | 12,2 | 12,3 | 12,3 | 12,3 |

Social benefits other than in kind | 16,7 | 16,6 | 16,7 | 16,7 | 16,5 |

Interest | 3,3 | 3,1 | 3,0 | 2,9 | 2,9 |

Subsidies | 1,4 | 1,3 | 1,2 | 1,2 | 1,2 |

Gross fixed capital formation | 2,5 | 2,4 | 2,4 | 2,5 | 2,5 |

Other expenditures | 3,8 | 3,8 | 3,9 | 3,8 | 3,8 |

Note : Including UMTS receipts. See footnote to Table I.1 .

Note : Data from the Commission October 2005 forecasts fro Italy have been used in order to estimate the aggregate value for 'Collective consumptions' and for 'Social benefits in kind'.

Source : Commission Spring 2006 forecasts.

4. Government revenue and expenditure

The developments in the EU and euro-area budgetary positions are derived from changes in expenditure and revenue ratios. On the spending side, the euro area expenditure-to-GDP ratio in 2005 stayed at the same level as in 2004, both in nominal and cyclically-adjusted terms (see Table I.4). The reductions in interest and subsidies offset the increases in social benefits. According to the Commission Spring 2006 forecasts, the expenditure ratio is projected to decline further during the forecast period with additional reduction of collective consumption and social transfers other than in kind, while other items are foreseen to remain broadly unchanged. On the revenue side, the revenue-to-GDP ratio increased in 2005, both in nominal and cyclically-adjusted terms and it is expected to decline in the coming years.

At the Member State level, the patterns are generally similar (see Table I.5). Only in Spain, Ireland, Italy, Portugal and the Netherlands and outside the euro area in the Czech Republic, Latvia, Poland and UK expenditure ratios are projected to increase over the 2005-07 period. In contrast, over the same period, large decreases are expected in Germany, Greece, Austria, Denmark, Lithuania, Slovakia, Hungary, Malta, Poland and Slovenia. Revenue ratios are set to increase pronouncedly over 2005-07 in the case of the Netherlands and Portugal and outside the euro area, in the UK, whereas important reductions are foreseen in Belgium, Austria, Finland, Denmark, Hungary, Lithuania and Malta.

In the euro-area, the projected decrease in tax revenues on income and wealth, social contributions and other resources is being offset by an expected decline in expenditure on collective consumption, social benefits other than in kind and interests. Such a development reflects lessons from the past showing that tax measures resulting in a decline of tax revenues should be accompanied by expenditure cuts to avoid the worsening of the general government balances.

Table I.5. Total revenue and expenditure in EU Member States. 2004-2007 (% of GDP)

Revenue | Expenditure |

2004 | 2005 | 2006 | 2007 | 2004 | 2005 | 2006 | 2007 |

BE | 49,4 | 50,1 | 49,3 | 48,5 | 49,5 | 50,1 | 49,7 | 49,5 |

Note : Including UMTS receipts. see footnote to Table I.1.

Source: Commission Spring 2005 forecasts.

Nevertheless, the composition of expenditure adjustment should not constrain growth enhancing spending items such as public investment, education and R&D. This doesn't seem to be the case as expenditure on gross fixed capital formation is broadly stable at around 2.5 percent of GDP at annual level. The reduction in interest expenditure that has particularly contributed to a better allocation of available resources in past years will slowly continue.

5. The fiscal stance and policy mix in the euro area

An appropriate policy mix can be defined as a combination of monetary and fiscal policies that ensures price stability and keeps economic activity close to its potential level. In the euro area, given that monetary policy is centralised and fiscal policies decentralised, it is of a particular importance to assess both the aggregate fiscal stance at the euro area level and national fiscal stances. Namely, the aggregate fiscal stance affects the policy mix at the euro area level and is, therefore, one of the elements to be considered by the ECB when setting the monetary policy.

Graph I.1 examines the fiscal stance (approximated by the changes in the cyclically-adjusted primary balance, CAPB) in relation to cyclical conditions (approximated by the size of the output gap).[?] In this graph, fiscal behaviour in accordance with the SGP would be represented by movements along the horizontal axis. In other words, countries would achieve and maintain broadly balanced budgets over the economic cycle. Thus, changes in the output gap would not imply movements in the CAPB. However, as long as a Member State has not yet reached the medium-term target of the SGP, a restrictive fiscal stance – that is a positive change in CAPB – would be needed.

According to the Commission Spring 2006 forecasts, the euro area fiscal stance in 2005 was slightly on the side of pro-cyclical fiscal tightening. Looking ahead to 2006 and 2007, the euro area fiscal stance is projected to become again broadly neutral. Lessons from the past show that efforts to improve the underlying budget positions should be made as economic conditions improve in order to ensure sufficient room for the automatic stabilisers to operate in the next downturn.

Graph I.2 illustrates the euro area policy-mix, by plotting the fiscal stance on the vertical axis and the monetary stance (approximated by the change in the short-term real interest rates) on the horizontal axis. Against the background of a protracted slowdown in economic activity, the monetary stance tightened somewhat and became more neutral in 2004, after three consecutive years of loosening. In 2005, it remained broadly neutral, while the euro area fiscal stance was being tightened.

Graph I.1. Euro-area fiscal stance and cyclical conditions. 2001-2007

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Source : Commission Spring 2006 forecasts.

Graph I.2. Euro-area policy-mix. 2001-2005

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Source : Commission Spring 2006 forecasts.

6. The fiscal stance and policy mix at the national level

The aggregate fiscal stance for the euro area results from a variety of diverse fiscal stances across Member States despite fairly similar cyclical developments, Graph I.3 shows that most EU-25 countries recorded a negative output gap in 2005 with the exception of Greece, Poland and the Baltic states.

In 2005, several EU countries ran moderately broadly neutral fiscal policies in a context of negative output gaps. Policies were, however, clearly countercyclical in the case of Portugal, Hungary, Italy and Luxemburg. It is worth mentioning that the nominal budget balances in these countries markedly worsened in the course of 2005.

The Netherlands, Cyprus and Malta ran pro-cyclical policy in 2005, reflecting consolidation efforts in order to improve the budgetary position. At the same time France also tightened its fiscal stance in order to bring the deficit below the 3 percent of GDP reference value.

As pointed out above, the overall policy-mix in the euro area in 2005 was characterised by a neutral monetary stance and tightened fiscal policy stance with most Member States experiencing an adjustment of the fiscal stance (see Graph I.4).

The real interest rate for the euro area (i.e. the short-term interest rate corrected by private consumption inflation) amounted to below 0.3 percent in 2005. However, this aggregate figure for the euro area conceals significant differences across Member States due to disparities in inflation rates across countries. The highest real interest rates were in France, Finland and Germany (1 percent, 0.9 percent and 0.9 percent, respectively), whereas in a number of countries (Belgium, Greece, Spain, Italy and Portugal) the real interest rates were negative.

Regarding 2006, the overall fiscal stance of the euro area is expected to be broadly neutral (see Graph I.5), although some pro-cyclical fiscal easing is expected, particularly in the Netherlands, Austria, Ireland, Finland and Belgium. Greece and Portugal are projected to considerably tighten their fiscal stances. Outside the euro area, Denmark, Hungary, the Czech Republic and Latvia are projected to substantially ease their fiscal stance, while the UK is expected to tighten it.

Graph I.3. Fiscal stance and cyclical conditions in the EU-25 Member States. 2005

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Source: Commission Spring 2006 forecasts .

Graph I.4. Policy-mix in the euro-area Member States. 2005

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Source : Commission Spring 2006 forecasts .

Graph I.5. Fiscal stance and cyclical conditions in the EU-15 Member States. 2006

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Source : Commission Spring 2006 forecasts .

8. Implementing the Stability and Growth Pact

9. Introduction

The fiscal framework of EMU aims at ensuring budgetary discipline through two main requirements. These are the Treaty requirement to avoid excessive deficit positions, measured against reference values for deficits and debt of 3 percent and 60 percent of GDP respectively, and the requirement for Member States to achieve and maintain their medium-term budgetary objective (MTO). Compliance with the MTO secures fiscal discipline and the sustainability of public finances, and thus contributes to maintaining an economic environment in which monetary policy can effectively pursue price stability. It also provides the necessary room for manoeuvre to allow the automatic stabilisers to play freely without breaching the 3 percent reference value of the Treaty.

The rules-based framework of the Treaty and SGP consists of both preventive and dissuasive elements, both of which are backed up with enforcement procedures. Box I.1 makes a description of these procedures. During 2005 and the early part of 2006, the Commission and Council applied the various enforcement mechanisms of the Stability and Growth Pact (SGP) against several Member States. This section reviews the implementation of these mechanisms since spring 2005 in the EU countries.

10. The excessive deficit procedure since spring 2005

Since spring 2005, the Commission and the Council took action concerning six Member States in EDP. The Commission and the Council considered that the Netherlands had corrected its excessive deficit and the Council decided to abrogate the excessive deficit procedure for this country on 7 June 2005. The Council decided to address a notice in accordance with Article 104(9) to Germany, which has to correct its excessive deficit in 2007. The Council decided that Portugal, the UK and Italy were in excessive deficit and set fiscal efforts and deadlines for their correction in 104(7) recommendations. Finally, the Commission and the Council considered that Hungary has not respected the recommendations formulated in the 104(7) recommendation. Since January 2006, twelve EU countries are subject to an excessive deficit procedure: five euro-area Member States, the UK and six new Member States.[?]

11. The surveillance mechanisms in the euro-area countries

Germany and France

Summary of past events

Following evidence of government deficits above 3 percent of GDP in 2002, the Council decided in spring 2003 that excessive deficits existed in Germany and in France and adopted recommendations under Article 104(7) with a view to bringing this situation to an end by 2004. In autumn 2003, the Commission considered that the actions implemented were inadequate and recommended the Council to adopt decisions giving notice to these two countries to correct the excessive deficit by 2005.

On 25 November 2003, the Council voted on the recommended decisions but did not achieve the required majority. Instead the Council adopted conclusions addressing recommendations to Germany and France for the correction of the excessive deficit by 2005 and stating that the excessive deficit procedure was held in abeyance. The Commission brought the case before the Court of Justice of the European Communities. On 13 July 2004, the Court annulled the Council conclusions in so far as they aimed at formally suspending the procedure and modifying the existing recommendations.

On 14 December 2004, the Commission adopted a Communication clarifying the situation of Germany and France in relation to the excessive deficit procedure. The Commission recognised that the actions of the two Member States concerned taken in the aftermath of the Council conclusions of 25 November 2003 and up to their annulment by the Court on 13 July 2004 were based on the notion that the deadline for the correction of the deficit had been effectively moved to 2005. The Commission considered that the assessment of the actions taken to correct the excessive deficit situation should refer to 2005 as the relevant deadline. In the Communication, the Commission stated that the actions taken by the German and French authorities were broadly consistent with a correction of the excessive deficit by 2005 and that no further steps were necessary under the excessive deficit procedure. The Council agreed with this position.

Germany

The German statistics office announced on 22 February 2006 that the public deficit in 2005 was 3.3 percent of GDP, down from 3.7 percent in 2004 but above the 3.0 percent reference value set in the Treaty. In addition, the deficit is expected by the German authorities to remain above the 3 percent of GDP threshold in 2006. The Commission recommended to the Council to give notice to Germany, according to Article 104(9) of the Treaty, to correct its excessive deficit by 2007. Such a notice was adopted by the Council on 14 March 2006. In this notice, the Council acknowledged that the German government that took office in November 2005 has adopted a comprehensive budgetary consolidation strategy in a context of still fragile economic recovery to bring the deficit below the 3 percent reference value by 2007.

The Commission and the Council considered that, on the basis of currently available information, the fiscal effort implied in the strategy until 2007 would be in line with the rules of the Stability and Growth Pact. Moreover, the Commission and the Council also considered that the adoption process of this strategy was well advanced, which reduces uncertainty regarding the effectiveness of the consolidation. The Council recommended in the notice that Germany corrects the excessive deficit by 2007 at the latest and ensures that the budget balance in structural terms (i.e. disregarding cyclical effects and one-off and temporary measures) improves by at least one percentage point cumulatively in 2006 and 2007. Germany shall submit to the Commission, by 14 July 2006 at the latest, a report outlining the measures taken to comply with the notice. Other reports should be submitted by 1 October 2006, 1 April 2007, 1 October 2007 and 1 April 2008, examining the progress made. The latest Commission forecast shows a deficit just above the reference value in 2006 and well below it in 2007.

Graph I.6. Budgetary plans, forecasts and outcomes in Germany

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Source: Commission services.

France

The French deficit was reduced to just below the reference value in 2005. The deficit reduction notably reflects large one-off revenues and statistical revisions. For 2006, the Commission projects a deficit at the reference value (including one-off revenues amounting to 0.2 percent of GDP). The no-policy change projection for 2007 shows a deficit slightly above 3 percent of GDP. Taking into account the uncertainties surrounding the deficit forecasts for 2006 and 2007, the Commission will continue in the coming months its monitoring of the budgetary developments in France and assess whether the correction of the excessive deficit is firmly established.

Graph I.7. Budgetary plans, forecasts and outcomes in France

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Source: Commission services.

Portugal

The update of the stability programme submitted on 9 June 2005 by the Portuguese authorities revealed the plans for a general government deficit in excess of the 3 percent of GDP reference value of the Treaty for the years from 2005 to 2007. More specifically, after a reported deficit outturn of 2.9 percent in 2004, Portugal planned to record a government deficit of 6.2 percent of GDP for 2005, 4.8 percent in 2006, 3.9 percent in 2007 and 2.8 percent of GDP in 2008. Over the same years, the debt-to-GDP ratio was projected to increase from 61.9 percent in 2004 to a peak of 67.8 percent of GDP in 2007. On this basis, the Council decided on 20 September 2005 that Portugal has an excessive deficit.

On the same date, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2008. Specifically, Portugal was recommended to limit the deterioration of the fiscal position in 2005 and to ensure a correction of the structural deficit of some 1.5 percent of GDP in 2006 from 2005, followed by a further decrease of, at least, ¾ percent of GDP in each of the two subsequent years. At the same time, Portugal was invited to rapidly implement reforms to contain and reduce expenditure and to stand ready to adopt the additional measures which may be necessary to achieve the correction of the excessive deficit by 2008. In addition, the Portuguese authorities were recommended to ensure that the government gross debt ratio is brought onto a downward path also by avoiding debt-increasing financial transactions, and by considering carefully the possible impact on debt of major public investment projects.

The Council established the deadline of 19 March 2006 for the Portuguese government to take effective action in order to achieve the 2006 deficit target. The Commission will carry-out an assessment of the efforts made by the Portuguese authorities in the coming weeks. This assessment will take into account the results of the spring 2006 Commission forecast that shows a 2006 deficit somewhat higher than recommended.

Graph I.8. Budgetary plans, forecasts and outcomes in Portugal

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Source: Commission services.

Greece

On 4 May 2004, the Greek authorities submitted a revised EDP notification showing a 2003 deficit of 3.2 percent of GDP. The Council, also taking into account developments in the debt ratio, decided that an excessive deficit exists in Greece and addressed on 5 July 2004 a 104(7) recommendation to Greece with a view to bringing the excessive deficit situation to an end by 2005. The Council established the deadline of 5 November 2004 for Greece to take appropriate measures to this end.

Based on its autumn 2004 forecast incorporating the data revisions of the September 2004 notification and projecting the 2005 deficit at 3.6 percent of GDP, on 22 December 2004 the Commission recommended to the Council to decide under Article 104(8) that no effective action had been taken in response to its 104(7) recommendation. The Council decided accordingly on 18 January 2005. On 9 February 2005, the Commission recommended to the Council to give notice to Greece, in accordance with Article 104(9) of the Treaty, to take the necessary measures to remedy its excessive deficit situation. The Commission recommended extending the deadline for bringing the deficit below the 3.0 percent reference value by one year to 2006. When taking this decision, the Commission took into account the fact that the 2004 deficit would likely be substantially higher than expected, due to statistical revisions and to expenditure overruns associated notably with the organisation of the Olympic games. In addition, the Commission considered that GDP growth prospects for 2005 and 2006 had become less favourable, making the reduction of the deficit more difficult.

On 17 February 2005, the Council adopted a decision giving notice to Greece, in accordance with Article 104(9) of the Treaty, to take measures to remedy the situation of excessive deficit as rapidly as possible and at the latest by 2006 through (i) a rigorous implementation of the 2005 budget as approved by the Parliament; (ii) implementing in 2006 adjustment measures of a permanent nature leading to a correction in the deficit of at least 0.6 percentage point of GDP.[?] The Council decided that Greece had to submit, by 21 March 2005 at the latest, a report outlining the decisions to respect these recommendations.

In March 2005, Greece submitted a report, which was assessed in the Commission Communication of 6 April. The Commission concluded that the Greek government had taken effective action so that no further steps under the EDP were needed at that stage. Greece submitted other reports in October 2005 and April 2006. Another report examining progress made in respecting the recommendations of the notice issued under 104(9) shall be submitted by 31 October 2006. For Greece, the spring 2006 Commission forecast shows a structural improvement in 2005 and 2006 that is in line with the Council notice under Article 104(9) but, given the upward revisions of past deficits, the deficit is at the reference value in 2006 only because of significant one-offs (0.6 percent of GDP).

Graph I.9. Budgetary plans, forecasts and outcomes in Greece

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Source: Commission services.

The Netherlands

In light of a reported general government deficit of 3.2 percent of GDP in 2003 and considering the risk that the deficit might remain above 3 percent of GDP in 2004, the Council placed the Netherlands in excessive deficit on 2 June 2004 and at the same time issued an Art. 104(7) recommendation for its correction. The Dutch government was recommended to put an end by 2005 at the latest to the excessive deficit. To that end, it was recommended to take action regarding corrective measures in 2005 amounting to at least half a percentage point of GDP by the deadline of 2 October 2004.

Following this recommendation, the Dutch authorities implemented an additional savings package for 2004 equivalent to 0.6 percentage point of GDP on top of the savings measures that had already been included in the 2004 budget. The corrective measures were for the largest part of a structural nature, thus having a deficit-reducing impact also in subsequent years. On 6 October 2004, the Commission considered that the Netherlands had taken effective action to correct the excessive deficit by 2005. The Council concurred to this analysis in its conclusions of 21 October 2004.

Based on data reported by the Netherlands of a deficit of 2,3 percent of GDP in 2004 and the Commission services’ spring 2005 economic forecast of a deficit at 2.0 percent in 2005, the Commission recommended on 18 May to the Council to abrogate its decisions under Article (6) and (7) of paragraph 104 of the Treaty. On 7 June 2005, the Council abrogated its decision on the existence of an excessive deficit in the Netherlands.

Graph I.10. Budgetary plans, forecasts and outcomes in the Netherlands

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Source: Commission services.

Italy

On 23 May 2005, Eurostat released revised figures on Italian government data, showing a general government deficit of 3.1 percent of GDP in both 2003 and 2004. Over the same two years, the debt-to-GDP ratio was reported to have remained broadly stable at around 106-107 percent of GDP. On 24 May the Italian institute of statistics (ISTAT) released new public finances data for the period 2000-2004. The deficit was reported at 3.2 percent of GDP in 2003 and 2004. Considering that the deficit ratio had been above but close to 3 percent of GDP in 2003 and 2004 and that the breach of the reference value could not be considered temporary because the deficit was projected by the Commission to exceed 3 percent in 2005 and 2006, and taking into account developments in the debt ratio, the Council decided that Italy has an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2007.

In particular, Italy was recommended to implement with rigour the 2005 budget; reduce the structural deficit by a minimum 1.6 percent of GDP by 2007 relative to its level in 2005, with at least half of this correction taking place in 2006; and ensure that the debt-to-GDP ratio diminishes and approaches the reference value at a satisfactory pace.

On 22 February, the Commission adopted a communication concluding that the actions taken by Italy, if fully implemented and effective, would be consistent with the Council recommendation. The Commission Communication highlighted that implementation uncertainties persist, which will require continuous monitoring. The Council agreed with this analysis. The spring 2006 Commission forecast shows that the deficit would remain unchanged at just above 4 percent of GDP in 2006 and rise further in 2007 on a no-policy change basis. This confirms the significant uncertainties surrounding the correction of the excessive deficit by 2007 that were highlighted in the Commission communication on the action taken in response to the Council recommendation.

Graph I.11. Budgetary plans, forecasts and outcomes in the Italy

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Source: Commission services.

12. The surveillance mechanisms in the non euro area Member States

United Kingdom

According to the data notified by the United Kingdom in August 2005, the general government deficit amounted to 3.2 percent of GDP in the 2004/05 financial year. The excess over the 3 percent of GDP reference value was not exceptional. In particular, it did not result from an unusual event outside the control of the United Kingdom authorities, nor was it the result of a severe economic downturn. The excess over the 3 percent of GDP reference value was also considered not temporary, based on the Commission services' autumn 2005 forecasts. Assuming that United Kingdom fiscal policy remained as announced, the deficit in these forecasts was expected to widen to just below 3½ percent of GDP in 2005/06 and to remain over 3 percent of GDP in 2006/07. Based on these projections, the excess over the reference value could not be considered exceptional or temporary within the meaning of the Treaty and the Stability and Growth Pact although the deficit is close to the reference value.

After the Commission services' autumn forecasts had been published, the United Kingdom announced policy decisions in the Pre-Budget Report presented to Parliament on 5 December. In net terms, these measures represented an easing of policy by 0.1 percent of GDP in the 2005/06 financial year and a tightening of policy by 0.1 percent of GDP in 2006/07. Compared to an unchanged policy scenario, the Pre-Budget Report foresaw a tightening of 0.2 percent of GDP in 2007/08. Taking into consideration these measures, the Commission's assessment remained that the deficit in 2006/07, at around 3.1 percent of GDP, was expected to exceed 3 percent of GDP. On this basis, the Council decided on 24 January 2006 that the UK had an excessive deficit.

On 24 January 2006, the Council considered that, in the case of the United Kingdom, the consideration of relevant factors did not warrant a departure from the standard deadline for correcting the excessive deficit. Therefore the Council decided that the United Kingdom authorities should put an end to the excessive deficit situation as soon as possible and by the financial year 2006/07 at the latest. To this end, the UK authorities should bring the general government deficit below 3 percent of GDP in a credible and sustainable manner and to this end ensure an improvement of the structural balance by at least 0.5 percentage points of GDP between the 2005/06 and 2006/07 financial years.

For the United Kingdom, the spring 2006 Commission forecast shows the deficit at the reference value in financial year 2006/07 and dropping below it in 2007/08.

Graph I.12. Budgetary plans, forecasts and outcomes in the UK

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Source: Commission services.

Hungary

On 5 July 2004, the Council issued a 104(7) recommendation to the Hungarian authorities to implement the measures envisaged in the May 2004 convergence programme aiming at a correction of the excessive deficit by 2008. The Hungarian authorities were recommended to stand ready to introduce additional measures, if necessary, with a view to achieving the deficit targets for 2004 and 2005.

On 18 January 2005, the Council considered that Hungary had not taken effective action in response to its recommendation. Having joined the Community on 1 May 2004, Hungary is a Member State with a derogation, which means that it is to avoid excessive deficits but that Articles 104(9) and Article 104(11) of the Treaty do not apply to it. The Council therefore issued on 8 March 2005 another recommendation based on Article 104(7), taking into account the information of Hungary’s convergence programme update submitted in December 2004. The Council recommended the Hungarian authorities to “take effective action by 8 July 2005 regarding additional measures, as far as possible of a structural nature, in order to achieve the deficit target for 2005 as set in the updated convergence programme".

On 13 July 2005, the Commission adopted a Communication stating that, based on the information available at the time that the Hungarian authorities had taken effective action regarding the 2005 budget deficit within the 4-month deadline set by the Council in its new 104(7) recommendations of 8 March 2005. The assessment underlined that the achievement of the 2005 deficit target of 3.6 percent of GDP might require further action later in the year and that important adjustments and decisive action would be needed to achieve the target of 2.9 percent of GDP in 2006 of the authorities. However, in light of a substantial deterioration of the budgetary outlook in Hungary, based on a Commission recommendation of 2 October 2005 incorporating the new information, the Council decided on 8 November 2005 that Hungary did not comply with the new 104(7) recommendations.

Graph I.13. Budgetary plans, forecasts and outcomes in Hungary

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Source: Commission services.

Czech Republic

On 5 July 2004 the Council decided that the Czech Republic had an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2008 in a credible and sustainable manner. In particular, the Czech Republic was recommended to take effective action regarding the measures envisaged to achieve the 2005 deficit target by the deadline of 5 November 2004 and to implement with vigour the measures envisaged in the May 2004 convergence programme, in particular to cut the wage bill of central government and to reduce spending of individual ministries. Furthermore, the Czech Republic was invited to allocate higher-than-budgeted revenues to deficit reduction, to introduce fiscal targeting based on medium-term expenditure ceilings, to design effective rules to reduce the risk of increasing indebtedness of regions and municipalities, to undertake the reform of the pension and healthcare systems so as to improve the long-term sustainability of the public finances and to minimise the negative budgetary impact of the operations of the Czech Consolidation Agency.

On 22 December 2004, the Commission concluded that the Czech government had taken effective action regarding the measures envisaged to achieve the 2005 deficit target in response to the Council recommendation, and that no further steps were necessary under the excessive deficit procedure. The Commission spring 2006 forecasts confirmed that the Czech Republic seems to be on track to correct the excessive deficit by 2008.

Graph I.14. Budgetary plans, forecasts and outcomes in Czech Republic

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Source: Commission services.

Cyprus

On 5 July 2004, the Council decided that an excessive deficit existed in Cyprus. At the same time, the Council addressed a recommendation to Cyprus under Article 104(7), requesting Cyprus to take effective action by 5 November 2004 in order to bring the deficit below 3 percent of GDP by 2005 in a credible and sustainable manner and to implement with vigour the measures envisaged in the May 2004 programme. Cyprus was also recommended, inter alia, to pursue the reform process in the pension and health care system in order to reduce the sustainability risks associated with the future evolution of age-related expenditures, together with the planned and necessary budgetary consolidation in the medium term.

A Commission communication of 22 December 2004 concluded that, on then available information and on the basis of the measures detailed in the 2005 budget, it appeared that the Cypriot government had taken effective action to achieve the 2005 deficit target, in compliance with the Council recommendation under Article 104(7). Accordingly, the Commission concluded that no further steps were necessary at that point under the excessive deficit procedure. The spring 2006 forecast of Commission services shows a deficit clearly below the reference value in 2005 (albeit thanks to a significant one-off) and expected to fall further by 2007 on a no-policy change basis (including small one-offs in 2006 and 2007).

Graph I.15. Budgetary plans, forecasts and outcomes in Cyprus

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Source: Commission services.

Malta

On 5 July 2004 the Council decided that Malta had an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2006. Malta was recommended to implement with vigour measures, particularly those of a structural nature, aimed at rationalising and reducing expenditure. The Council also recommended that the rise in the debt ratio is brought to a halt in 2005 and reversed thereafter.

The Commission Communication to the Council of 22 December 2004 concluded that, on the basis of the measures contained in the 2005 budget, Malta appeared to have taken effective action regarding the measures to achieve the deficit targets for 2005 in response to the Council Recommendation. According to the spring 2006 forecast of Commission services, Malta seems to be on track to correct the excessive deficit by 2006.

Graph I.16. Budgetary plans, forecasts and outcomes in Malta

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Source: Commission services.

Poland

On 5 July 2004, the Council decided that Poland had an excessive deficit. At the same time, the Council addressed a recommendation under Article 104(7) specifying that the excessive deficit had to be corrected by 2007. In particular, Poland was recommended to implement with vigour the measures envisaged in the convergence programme, in particular those contained in the so-called Hausner plan. This plan was proposed in 2003 and aimed at reducing public expenditure on social protection, public administration and state aid. The Polish authorities were recommended to take effective action by 5 November 2004 regarding the measures envisaged to achieve the 2005 deficit target. In addition, the Council invited the Polish authorities to allocate possible extra revenues to decrease the general government deficit.

On 22 December 2004, the Commission sta