Communication from the Commission to the Council and the European Parliament - Public finances in EMU - 2002 [SEC(2002) 518]
Date: 2002-05-14
Institutions: European Commission
Subjects: Economic and Monetary Union, budget policy, public finance

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 14.5.2002
COM(2002) 209 final

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL
AND THE EUROPEAN PARLIAMENT

Public finances in EMU - 2002

{SEC(2002) 518}

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE
EUROPEAN PARLIAMENT

Public finances in EMU - 2002

Fiscal policies in the recent juncture: responding to the cyclical slowdown …

2001 proved to be the most challenging period for fiscal policy in the three-year history of EMU
as  the  global  slowdown  provided  the  first  real  stress  test  of  EMU’s  multilateral  surveillance
framework, and especially its budgetary dimension. The budget deficit for the euro area reached
1.3%  of  GDP,  up  from  0.7%  in  2000.  Despite  this  first  reversal  in  the  process  of  budgetary
consolidation since 1993 and criticism about perceived failure to strictly adhere to the provisions
of the Stability and Growth Pact (SGP), there are several grounds for considering the framework
for  budgetary  aspects  of  the  multilateral  surveillance  framework  have  performed  well  in
responding to the cyclical slowdown.

Firstly,  Member  States  had  scope  to  let  the  automatic  stabilisers  operate  so  as  to  cushion  the
negative  shock.  This  was  especially  the  case  in  countries  which  had  already  achieved  a  budget
balance or surplus. Automatic stabilisers were also allowed to work in countries that had not yet
completed the transition to the close-to-balance target of the SGP. However, deficits in Germany
and Portugal started to rise and approach the 3% of GDP reference value.

Secondly,  countries    did  not  embark  on  unwarranted  expansionary  policies.  Fiscal  authorities
came  under  considerable  pressure  to  relax  consolidation  commitments  and  resort  to  active
demand management in response to the global slowdown. The structural budget deficit in 2001
of 1.5% of GDP is almost unchanged compared with 2000: this illustrates that the deterioration
in the actual budget balances was mostly due to operation of the automatic stabilisers. Indeed, it
is worth noting that despite the slowdown, actual budget balances were unchanged in Belgium,
Denmark and Italy and indeed improved in Greece, Spain, Austria and Sweden.

Thirdly, Member States have been able to continue with planned tax reforms designed to remove
supply side rigidities, despite claims from different quarters  that the SGP was unnecessarily tying
the hands of the authorities through arbitrary and inflexible rules. What EMU’s budgetary rules
emphasise  is  the  need  to  accompany  these  tax  reforms  with  appropriate  measures  on  the
spending  side  given  the  fact  that  tax  reductions  are  seldom  self-financing.  Such  measures  are
paramount to guarantee the sustainability of tax reforms and thus should reinforce their impact
on investment and consumption.

The  confirmation  of  the  commitment  to  the  rules  and  spirit  of  the  SGP  helped  achieve  a
balanced  policy  mix  which  was  supportive  to  growth  while  guaranteeing  price  stability.  Whilst
fiscal policies remained broadly neutral, monetary conditions eased markedly. Such a policy mix is
appropriate  not  only  from  a  cyclical  standpoint,  but  also  in  a  medium  and  longer  term
perspective,  considering  the  need  to  boost  private  investment  and  potential  growth  and  to
prepare for the budgetary pressures of ageing populations. Recent short-term indicators point to
a turnaround in the European economy, and thus expansionary measures may ex post have turned
out  to  be  pro-cyclical.  This  assessment  of  the  performance  of  the  framework  for  budgetary
surveillance needs to be tempered with caution as the recent  downturn was neither particularly
severe or prolonged. Budgetary positions of “close to balance or in surplus” are still not met in all
countries.  Rapidly  achieving  such  targets  is  the  best  way  to  ensure  that  Member  States  have
sufficient room for manoeuvre should a recession arise in the future.

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… while continuing to improve EMU’s fiscal framework

In early 2002, attention has mostly focussed on the cyclical response to the slowdown and on the
procedures for dealing with slippage from budgetary targets,  especially the debate on whether an
early-warning  recommendation  should  be  issued  to  Germany  and  Portugal.  However,  it  is
important not to overlook a number of significant measures that have strengthened  the quality
and  coverage  of  budgetary  surveillance,  and  improved  the  analytical  tools  available  to  the
Commission and Council for policy assessment. While seemingly technical, these are important
advances which will help improve the coherence and effectiveness of EMU’s fiscal framework.

Firstly  in  July  2001,  the  ECOFIN  Council  revised  the  Code  of  Conduct  on  the  content  and
presentation  of  stability  and  convergence  programmes  (which  dated  from  1998)  taking  into
account the experiences of three years in EMU. Member States applied the Code to the recently
updated programmes. The revised Code provides for a clustered submission of programmes with
budgetary  targets  based  on  external  macroeconomic  assumptions  that  have  been  agreed  in
common. It also clarifies  the  interpretation as  to  what  constitutes  an  appropriate  medium-term
target of ‘close to balance or in surplus’ for each Member State. Finally, it extends the coverage of
programmes to include sections on the quality and sustainability of public finances in line with
the  Lisbon  conclusions.  The  most  important  result  of  the  application  of  the  new  Code  is
probably  the  improved  ability  to consider  the  implications  for  the  euro  area  as  a  whole  of  the
budgetary policies outlined in the national programmes. This was particularly valuable given the
high degree of uncertainty surrounding the economic situation at the end of 2001 and beginning
of  2002.  In  time,  this  will  also  allow  the  euro  area  dimension  to  be  increasingly  factored  into
national budgetary policies.

Second,  the  economic  downturn  underlined  the  importance  of  paying  close  attention  to  the
cyclically-adjusted  budget  balances  when  examining  the  budgetary  positions  of  Member  States.
While measuring the impact of the economic cycle on budget positions is complex and subject to
uncertainties, it is important that all actors involved in the surveillance process have a common
view  on  the  underlying  budgetary  developments.  Inter  alia,  the  cyclical  adjustment  of  budget
balances  is  used  when  evaluating  the  minimum  cyclical  safety  margins  under  the  3%  of  GDP
reference value and the respect of the “close to balance or in surplus” target of the Stability and
Growth  Pact.  In  order  to  ensure  consistency,  broad  agreement  has  been  reached  between  the
Commission and Council on a method to measure cyclically adjusted budget balances based on a
production function approach to estimating the output gap.

Third,  a  major  extension  of  EU  budgetary  surveillance  was  achieved  with  the  first  systematic
assessment of the sustainability of public finances in light of ageing populations. This was made
on the basis of the updated stability and convergence programmes  submitted  in late  2001. The
analysis shows the potential risk for emerging budgetary imbalances in many Member States, and
emphasises  the  importance  of  achieving  and  sustaining  the  medium-term  targets  set  down  in
their programmes.

The importance of the early-warning system

A critical juncture in the budgetary surveillance process was reached in January 2002, only weeks
after the introduction of euro notes and coins, when the European Commission recommended
that an early-warning be  sent to Germany  and  Portugal under  the SGP. Both countries missed
the targets for 2001 set down in their stability programmes by a wide margin (over 1% of GDP),
and there was a clear risk of deficits approaching the 3% of GDP reference value for the budget
deficit.  In  the  face  of  such  clear-cut  slippage  from  agreed  targets,  the  Commission  acted  to
preserve credibility of  the legal and political obligations of the Pact. As a result of discussions in
the  ECOFIN  Council  on  the  Commission’s  draft  recommendation  for  an  early-warning,

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Germany and Portugal gave firm political commitments which responded to the substance of the
Commission’s  concerns:  the  Council  therefore  decided  to  close  the  procedure.  Both  countries
reiterated their willingness to avoid a breach of the 3% of GDP reference value, to resume the
process of budgetary consolidation and to reach their medium-term targets by 2004. At the same
time the Council  restated the importance of the early-warning system  in  the  overall framework
for budgetary surveillance and confirmed that the Commission had acted in accordance with  the
provisions of the Pact.

The credibility of the rules-based framework for the co-ordination of budget policies will have to
receive particular attention in the future. A relevant distinction here is between the process of the
early-warning and its outcome.  It is important to avoid a perception in public opinion that the
rules  can  be  changed  or  at  least  avoided  in  challenging  circumstances.  Commitment  to  the
framework for budgetary surveillance was confirmed by the Council and so was the importance
of the SGP. The early-warning procedure can and will be used again if the need arises. Obviously,
to  maintain  the  credibility  of  the  SGP,  it  is  important  that  the  commitments  of  Germany  and
Portugal  are  implemented  in  full.  Positive  evidence  is  emerging  that    these  commitments  are
being taken seriously. In particular, following the agreement in the ECOFIN Council of February
2002, a domestic stability pact between the Länder and the Bund in Germany has been agreed.

Looking to the future: attaining the goal of the Stability and Growth Pact …

Maintaining credibility in the SGP also requires the Commission and Council to demonstrate a
capacity to learn from this first experience with the early-warning mechanism. While the SGP has
undergone the first real stress test and the economic situation is forecast to improve, there is no
room for complacency. Important budgetary challenges remain to be tackled.

First of all, once economic  recovery  has gathered  pace,  the  budgetary consolidation  process  to
meet  the  ‘close-to-balance’  rule  of  the  Pact  must  start  again  and  any  lost  ground  should  be
quickly recovered. In the latest updates of stability and convergence programmes, Member States
which still have a budget deficit confirm their commitment to reach the medium-term target of
the SGP by 2003 or 2004. Moreover, the budgetary adjustment planned for coming years will be
achieved via  reductions in both revenue  and  expenditure,  in  line with  the  recommendations  of
the BEPGs. Meeting the budgetary commitments to reach the medium-term targets foreseen in
the stability and convergence programmes is paramount to underpin the credibility of the Pact.
This  is  especially  the  case  for  the  four  countries  still  in  deficit  (Germany,  France,  Italy  and
Portugal).

Second, as past experience shows, budgetary mistakes tend to occur mainly in good times. The
debate back in 2000 on how to distribute the so-called “growth dividends” between tax cuts and
spending  increases  defy,  as  the  Commission  pointed  out  at  the  time,  not  only  the  rules  of  the
SGP,  but  also  economic  logic.  It  is  important  not  to  consider  improvements  in  the  budget
balance  due  to  a  favourable  economic  juncture  as  permanent,  thus  providing  scope  for  tax
reductions or expenditure increases. The budgetary constraint affecting mainly the large euro area
countries  in  2001  and  2002  have  their  roots  in  the  missed  opportunities  of  the  high-growth
period  1998-2000.  Preventing  a  deterioration  in  structural  budget  balances  during  upturns  is
probably the most daunting challenge for the SGP. Surveillance will need to ensure that countries
still  not  complying  with  the  requirements  of  the  Pact  take  the  opportunity  of  the  recovery  to
accelerate  fiscal  retrenchment  while  the  others  let  automatic  stabilisers  operate  fully.  In  brief,
financing  tax  reductions  and  spending  rises  via  the  automatic  fruit  of  economic  growth  or
accelerating the tax cuts as soon as growth revives is misguided both from the point of view of
fiscal prudence and cyclical stabilisation.

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Third, there is a need to discuss the desirability and effectiveness of discretionary fiscal policy. If
countries  abide  by  the  SGP’s  fiscal  philosophy,  they  will  choose  a  broadly  balanced  budget  in
structural terms and let automatic stabilisers play freely over the cycle. This is based on the well-
known  pitfalls  of  active  fiscal  management  (implementation  and  recognition  lags,  model
uncertainty,  measure  irreversibility,  etc.).  The  circumstances  under  which  counter-cyclical
discretionary fiscal actions (going beyond the operation of the automatic stabilisers) may be both
desirable  and  effective  are  very  narrow:  they  could  be  envisaged  in  the  event  of  large  country-
specific demand shocks originating domestically and entailing strong inflationary or deflationary
pressures. Even in these cases, however, the risk that an ex ante counter-cyclical policy becomes
ex  post  pro-cyclical  is  high.  Moreover,  the  room  for  manoeuvre  for  the  discretionary  stimulus
would have to be created in order not to breach the 3% of GDP deficit ceiling. For a number of
countries, this would imply going beyond the close-to-balance rule of the Pact. A clear agreement
between  the  EMU  policy  actors  on  the  criteria  to  assess  discretionary  fiscal  policies  would
increase  the  transparency  and  predictability  of  budgetary  behaviour.  While  the  role  for
discretionary  should  be  confined  to  critical  country  specific  shocks,  this  does  not  mean  that
policy  co-ordination  should  be  confined  to  exceptional  circumstances.  By  its  very  nature,
occasional  co-ordination  is  ill-suited  for  implementing  a  consistent  macroeconomic  strategy  in
both  normal  and  exceptional  situations.  Policy  co-ordination  –  viewed  as  a  system  to  attain  a
common assessment of the economic situation, agree on the orientation of the policy response
and monitor their implementation – should be regular, not occasional.

Finally,  several  Member  States  are  trying  to  improve  the  compatibility  between  their  national
fiscal  rules  and  EU  budgetary  commitments.  The  Treaty  and  the  Pact  leave  it  up  to  Member
States  to  determine  their  own  budgetary  procedures  to  achieve  SGP  targets.  However,  the
financial  relevance  of  regional  governments  and  other  sub-sectors  of  the  government  in  the
budget process in federal states and strongly regionalised states (Belgium, Germany, Spain, Italy
and Austria) has highlighted the necessity for Member States to find solutions to secure sustained
discipline  at  all  levels  of  government.  To  address  this  coordination  problem,  several  Member
States  have  already  adopted  special  arrangements  among  government  levels,  in  what  could  be
termed ‘internal stability pacts’. A common characteristic of these pacts is the effort to clarify and
share the responsibility for budget discipline among the different  levels of government.

… while addressing the long run sustainability of public finances

Fiscal discipline is not only about running sound public finances in the short to medium-term. It
also requires that public finances are sustainable in the long run, i.e. that current budget policies
do not lead to or risk causing future budgetary imbalances in breach of SGP requirements due to
the  budgetary  effects  of  ageing  populations.  Sustainability  also  requires  that  age-related
expenditures  (pensions,  health  care)  do  not  crowd-out  other  essential  public  spending  such  as
investment  and  R&D.  Moreover,  future  generations  should  benefit  from  an  adequate  public
capital stock and should not face an unfair tax burden.

The  information  included  in  the  stability  and  convergence  programmes  shows  that  ageing
populations will have a considerable budgetary impact. Public spending is projected to increase
by between 4% and 8% of GDP in the coming four decades in most Member States, although
much  higher  increases  are  projected  in  several  countries.  Increases  in  public  spending  due  to
ageing populations will start as of 2010 as the baby-boom generation enter into retirement, and
the steepest increases will occur usually between 2020 and 2035.

The analysis shows that on the basis of current policies, there is a risk of budgetary imbalances
emerging in many Member States, and these risks multiply if countries fail to reach the medium-
term  targets  set  down  in  their  stability  and  convergence  programmes.  All  countries  will  face  a
budgetary challenge posed by ageing populations, even those which appear to be well placed to

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meet  the  growth  in  age-related  expenditures.  In  high-debt  countries  (Belgium,  Greece  Italy)
sustainability is dependent upon running large budget surpluses over several decades, illustrating
the continued need to give preference to debt reduction over the long run. Other Member States
face  a  challenge  of  meeting  the  additional  costs  of  ageing  populations  while  at  the  same  time
pursuing other budgetary objectives, notably keeping the tax burden at reasonable levels.

Faced with this challenge, several countries have put in place comprehensive strategies, including
measures to raise employment rates especially amongst women and older workers, reform of age-
sensitive  transfers  programmes,  and  commitments  to  run  sustained  budget  surpluses  so  as  to
achieve a rapid reduction in public debt levels prior to the impact of ageing populations taking
hold. However,  the ambitious and comprehensive reforms of some Member States contrast with
rather  piecemeal  approaches  in  other  countries  which  fail  to  recognise  the  seriousness  of  the
policy challenge. Several countries have established pension reserve funds in recent years to meet
future expenditure increases. While this is a welcome development, the extent to which they will
meet  future  costs  is  questionable  (with  the  exception  of  Ireland)  given  the  limited  resources
which have already been invested in them and uncertainty as regards the size and frequency of
contributions.  Overall,  policy  makers  need  to  be  more  aware  that  it  is  short-  to  medium-term
budgetary  choices  which  determine  the  capacity  of  countries  to  meet  the  budgetary  costs  of
ageing populations.

New frontiers of budgetary surveillance and coordination: factoring in the “quality” of
public spending …

Public spending has risen sharply in the EU over the past three decades to 47% of GDP in 2001,
having  declined  during  the  Maastricht  process  of  budgetary  consolidation  from  over  51%  of
GDP in 1995.  The average size of the government sector in the EU remains well above levels in
other  industrialised  countries  and  is  15  percentage  points  of  GDP  above  that  in  the  US.  The
aggregate picture, however, hides considerable disparity in the size of the government spending
across Member States.

Public spending on the basic function of the State and other measures to improve the allocation
of  resources  (defence,  justice,  education,  health  care,  R&D,  economic  services)  has  remained
remarkably  stable  over  the  past  30  years,  and  is  very  similar  (between  14%  and  16%  of  GDP)
across EU countries. The difference in overall government spending levels in the EU compared
with  the  US  mainly  reflects  spending  on  social  protection  programmes,  this  being  a  typical
feature of the European Social Model. The largest increases in spending on social protection have
been recorded in countries that had relatively immature social protection systems at the beginning
of the 1980s. Conversely, countries with high levels of spending in the early 1980s have started in
the last decade to reduce the amount of resources devoted to social welfare.

The stricter  budget constraint  facing  Member States in EMU, coupled with efforts  to  raise  the
employment  and  growth  performance  as  part  of  the  Lisbon  agenda,  requires  that  greater
attention be paid to  how  public resources are spent and how taxes are levied. However, cross-
country  analyses  have  been  hampered  by  the  lack  of  timely  and  comparable  data  on  the
functional  classification  of  public  expenditures.  As  a  consequence,  while  considerable  progress
has  already  been  accomplished  on  long  term  sustainability  of  public  finances,  whereas
surveillance of the quality of public finances, as required by the European Council, is still at an
early stage.

The difficulty in putting in place an effective monitoring of the quality of public spending is also
due to the conceptual difficulty in defining what ‘quality’ actually means. A certain composition
of public expenditure could be considered as ‘high quality’ if it makes a positive contribution to
the goals of the Lisbon strategy, i.e. making the Union the most dynamic, competitive, knowledge

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based  economy,  enjoying  full  employment,  strengthened  economic  and  social  cohesion  and
environmental sustainability. On this basis, Member States can promote growth and employment
by redirecting public expenditure towards physical and human capital accumulation and research
and  development.  Investment  in  human  capital  and  infrastructure  can  have  a  robust  effect  on
long-term growth and new innovative approaches to financing should be sought, including public
private  partnerships.  Appropriate  spending  on  social  welfare,  together  with  an  appropriate  tax
policy,  can  contribute  to  equity  and  can  also  have  a  positive  impact  on  growth  and  economic
efficiency.

Countries appear to have been able to improve the composition of public expenditure while at
the  time  containing  the  size  of  the  public  sector  during  the  1990s.  In  this  context,  it  is  worth
mentioning that the EU budget complemented Member States’ expenditure in growth promoting
categories such as investment and R&D. Before drawing firm policy conclusions about the level
and composition of public spending, it is essential to conduct microeconomic analysis that takes
into  account  the  specific  aims  of  spending  programmes,  their  design  and    linkages  with  other
policy instruments. A precondition for doing so is the availability of suitable data, the elaboration
of which has already been identified as a priority area by successive European Councils.

… and preparing for enlargement

Accession  negotiations  are  currently  underway  with  twelve  of  the  thirteen  candidate  countries
who  wish  to  join  the  EU.  The  Treaty  provisions  and  secondary  legislation  (the  acquis
communautaire) on economic and budgetary policy will apply to these countries once they join the
EU. A major policy challenge is to implement upon accession the EU framework for budgetary
surveillance taking into account the specific needs and circumstances of the candidate countries.
Key budgetary issues are faced by a sub-set of candidate countries, namely the ten countries from
central and eastern  Europe (CEECs)  as they approach entry  into  the  EU  and,  differently  from
the other candidate countries, undergo a transition from a command to a market economy.

The  overall  relative  level  and  composition  of  revenues  and  expenditures  in  CEECs  resemble
those in present EU Member States, although significant differences for individual countries and
budgetary components exist at times.  This is a remarkable fact since CEECs have had only ten
years to implement ex novo a fiscal system. While the size of CEECs governments is on average
higher than in most emerging economies, this can be largely explained by  underlying economic
factors.  There  remains,  however,  a  need  to  reassess  the  structure  of  budget  revenues  and
expenditures to foster a growth-enhancing environment providing sufficient space and incentives
for private sector development.

A key requirement for budgetary surveillance are reliable and timely government accounts. This
has proved to be difficult for countries undergoing a transition to a market economy. From an
institutional point of view, treasury departments had to be created and far-reaching modifications
were  required  to  accounting  and  recording  procedures.  Developing  the  capability  to  provide
timely and reliable data with  an appropriate coverage has  been a  lengthy  task,  which  is  not  yet
completed  and  there  is  scope  for  further  improving  the  quality  of  budgetary  data.  From  a
conceptual point of view, the transition to a market economy is shifting the boundaries between
the  state  and  the  private  sector,  making  it  somewhat    difficult  to  interpret  and  compare
government accounts in the CEECs. Many of the underlying problems, however, are decreasing
as transition advances and the acquis communautaire is progressively implemented.

Budgetary  surveillance  will  also  need  to  take  into  account  that  the  CEECs  are  undergoing
tremendous  structural  and  institutional  changes.  These  changes  are  not  only  driven  by  the
completion  of  a  move  from  a  command  to  a  market  economy,  but  also  by  the  liberalisation
effects  which  EU  membership  will  entail,  the  need  to  upgrade  public  infrastructure  and  the

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commitment  to  implement  the  acquis  communautaire,  with  the  related  institution  building
requirements.  All  of  these  changes  have  significant  budgetary  implications  that  need  to  be
factored  into  the  evaluation  of  the  budgetary  situation.  In  addition,  due  consideration  must  be
given  to  the  constraints  imposed  by  the  fact  that,  on  average,  CEECs  are  characterised  by  a
higher degree of volatility in output levels compared with EU Member States and are small open
economies which rely heavily on foreign capital to finance catching up.

Since  2001,  the  Commission  has  implemented  a  new  initiative  called  the  Pre-accession  Fiscal
Surveillance Procedure (PFSP) which is designed to closely approximate the policy co-ordination
and surveillance mechanisms of the EU while giving due regard to the accession priorities of the
candidate  countries.  The  assessment  of  budgetary  positions  in  the  run  up  to  accession  should
therefore  be  flexible  enough  to  cater  for  the  uncertain  and  fast  changing  circumstances  facing
economies undergoing rapid change, but at the same time rigorous enough to cater for the very
real challenge facing the CEECs.

Accordingly,  in  the  run  up  to  accession,  candidate  countries  are  required  to  comply  with  the
Copenhagen  criteria  rather  than  fulfilling  the  Maastricht  nominal  convergence  criteria.  The
primary  concern  in  the  pre-accession  period  is  medium-term  macroeconomic  stability,  rather
than achieving any particular target for the budget balance. Medium-term budgetary policy should
also pursue a structure of expenditure and revenues that effectively supports economic growth.
At  the  same  time,  the  emphasis  on  structural  and  institutional  reform  should  not  hide  the
importance of  sound fiscal policies.  CEECs’ vulnerability to  economic  shocks  and  the external
constraints they  face underline the need for prudent policies. The  appropriate deficit  level  may
vary across countries  and  is  likely  to  be  a  function  of  elements  such  as  the  speed  of  structural
reforms, the relative speed of economic growth, the extent of real convergence and the level of
debt.

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