Communication from the Commission to the Council and the European Parliament - Public finances in EMU - 2003 {SEC (2003) 571 }
Date: 2003-05-21
Institutions: European Commission
Subjects: EU Member State, budget deficit, budget policy, coordination of EMU policies, economic situation, enlargement of the Union, public finance, stability programme

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 21.5.2003
COM(2003) 283 final

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE
EUROPEAN PARLIAMENT

Public finances in EMU – 2003

{SEC (2003) 571 }

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL AND THE
EUROPEAN PARLIAMENT

Public finances in EMU – 20031.

The  most difficult period for budgetary policies since the launch of the euro

2002 and the early part of 2003 has been a difficult period both in terms of actual budgetary
developments and as regards the implementation of the EU framework for fiscal surveillance.
The nominal deficit for the euro area as a whole increased from 1.6% of GDP in 2001 to 2.2%
in  2002  and,  according  to  the  latest  Commission  forecast,  it  is  projected  to  rise  to  2.5%  of
GDP  in  2003.  This  aggregate  outcome  is  the  result  of  striking  contrasts  in  the  performance
across Member States.  By  the  end  of  2002, only six EU countries, including  four  euro  area
countries (accounting for some 18% of euro area output) had achieved budget positions (both
in  nominal  and  cyclically  adjusted  terms)  that  met  the  'close  to  balance  or  in  surplus'
requirement of the Stability and Growth Pact, whereas two euro area countries (accounting for
half of the euro area output) had deficits above the 3% of GDP reference value.

The Portuguese authorities succeeded in reducing the nominal deficit from 4.1%  of GDP in
2001 to 2.8% in 2002, although very significant challenges remain if the deficit is to remain
below 3%  of  GDP  in  2003  as  much  of  this  improvement  is  due  to  one-off  measures  which
have only led to a transitory improvement in the budget balance. A deficit of 3.6% of GDP in
2002  has  resulted  in  Germany  being  placed  in  an  excessive  deficit  position:  while  the
authorities are taking measures aimed at reducing the cyclically-adjusted budget deficit, only
a  very  limited  improvement  in  nominal  terms  is  expected  in  2003  as  growth  conditions
deteriorate. Despite clear evidence of budgetary slippage emerging in early 2002, the French
authorities did not take corrective measures and a deficit of  3.1% of  GDP occurred in  2002
resulting in the excessive deficit procedure being activated. An even higher deficit of 3. 7% of
GDP is forecast by the Commission services for 2003 on the basis of current policies. Large
deficits remain in Italy (2.3% of GDP in 2002 and in 2003) and by 2004 is projected to rise
above  the  3%  of  GDP  reference  value2:  budgetary  consolidation  efforts  in  Italy  continue  to
rely  on  one-off  measures  rather  than  on  reforms  of  a  structural  nature  needed  to  ensure  a
permanent  improvement  in  the  budget  balance.  Deficits  have  also  re-emerged  in  2002  in
countries that already had reached balanced budget positions, notably Austria (0.6% of GDP),
the Netherlands (1.1%) and the UK (1.3%).

Higher nominal deficits are only partly due to the economic  cycle

At  first  sight,  these  developments  compare  relatively  favourably  with  previous  economic
downturns  when  deficits  reached  much  higher  levels  and  debt  ratios  entered  rapidly
increasing  trajectories.  In  addition,  governments  have  not  pursued  fine-tuning  policies  and
while  fiscal  policies  were  slightly  looser,  monetary  conditions  have  eased  thanks  mainly  to
low real interest rates.

1 
2 

See also the report by the Commission services on “Public Finances in EMU 2003”, SEC ……..
European  Commission  Spring  2003  forecast,  2004  figures  are  based  on  the  assumption  of  no  policy
change.

2

                                                
However, a closer consideration of underlying budgetary trends reveals that the deterioration
in  nominal  deficits  also  results  from  high  and  rising  cyclically-adjusted  deficits  in  several
countries. This indicates a discretionary loosening of the fiscal stance by some Member States
over the past two years, brought about by a combination of unfunded tax cuts, discretionary
expenditure increases and failures as regards budgetary execution. While the outcome of the
euro area in  2002  was  unchanged  compared  to  2001,  it  should  be  noted  that  the  cyclically-
adjusted  budget  balance  for  2001  has  recently  been  revised  upwards  to  2.1%  of  GDP  from
1.5%  of  GDP,  implying  that  the  deterioration  in  the  underlying  budget  balance  in  that  year
was  considerably  worse  than  earlier  estimates  showed:  moreover,  the  cyclically-adjusted
budget  balance  includes  the  impact  of  one-off  budgetary  measures  which  only  have  a
transitory  effect  on  budget  positions.  The  deterioration  has  been  particularly  pronounced  in
Germany (where the CAB increased to 3.2% of GDP in 2002) and France (to 3.3%). In Italy,
it remains high at 2.1% of GDP.

In a medium-term perspective, the latest updates of the stability and convergence programmes
contain a target by  most Member States  to  reach budget positions  of  'close  to balance  or  in
surplus'  by  2005  or  2006.  However,  it  should  be  noted  that  the  medium-term  targets  of
Member  States  are  based  on  growth  assumptions,  which  in  light  of  developments  in  recent
months  now  appear  to  be  optimistic.  In  countries  where  large  cyclically  adjusted  deficits
remain,  the  time  frame  for  reaching  the  ‘close  to  balance  or  in  surplus’  objective  has  been
pushed  back  to  2006  or  2007:  even  this  date  will  only  be  met  if  additional  consolidation
measures are undertaken.

Commission proposals to strengthen the co-ordination of budgetary policies

The deterioration in budget positions has placed  considerable stress on the EU’s  framework
for  fiscal  surveillance  and  three  Member  States  have  been  placed  in  excessive  deficit
positions. In response to these developments, and in line with a mandate from the Barcelona
European Council conclusions, the Commission  adopted a Communication on strengthening
the  co-ordination  of  budgetary  policies.3  It  identified  a  number  of  shortcomings  with  the
implementation of the SGP  in  the first four  years  of  EMU  and outlined  a strategy based  on
Member  States  reassuming  political  ownership  of  the  Pact.  Inter  alia,  it  called  for  more
account to be taken of underlying  economic conditions when  assessing  budgetary positions,
an  interpretation  of  compliance  with  SGP  requirements  that  would  (depending  on  country
specific  circumstances)  cater  for  the  budgetary  impact  of  reforms  that  enhance  growth  and
employment,  increasing  the  emphasis  placed  on  the  sustainability  of  public  finances  and
outstanding  debt  positions,  and  improving  the  implementation  of  the  SGP  including  stricter
and  more  timely  recourse  to  the  existing  enforcement  instruments.  At  the  same  time  the
Commission  adopted  proposals  to  improve  the  governance  of  budgetary  statistics  which
provide the foundations for effective surveillance.

The European Council of March 2003 endorsed key conclusions of the ECOFIN Council

The  Spring  European  Council  of  March  2003,  endorsed  a  report  of  the  (ECOFIN)  Council
which  shared  many  of  the  Commission’s  proposals  on  strengthening  the  co-ordination  of
budgetary policies. It confirmed that the achievement of a budget position of 'close to balance
or  in  surplus'  is  in  the  economic  self-interest  of  Member  States  both  individually  and
collectively. In the short run, it provides room for the automatic stabilisers to operate freely
and cushion the effect of economic shocks; in the medium-run it creates room for budgetary
manoeuvre  to  either  cut  taxes  or  divert  expenditures  to  more  productive  items  such  as

3 

Communication  from the Commission  “Strengthening the co-ordination  of  budgetary  policies”,  COM
(2002)668 final of 27 November 2002.

3

                                                
investment  and  R&D;  in  the  long-run,  compliance  will  help  Member  States  meet  the
budgetary  costs  of  ageing  population  while  securing  adequate  and  accessible  pensions  and
health care.

In  addition  to  re-stating  their  commitment  to  the  goal  of  the  SGP,  the  Council  agreed  that
compliance  with  the  'close  to  balance  or  in  surplus’  requirement  should  be  assessed  in
cyclically-adjusted terms with due account  taken of one-off budgetary measures which  only
have a transitory impact on budget positions. For euro-area countries, agreement was reached
that  Member  States  with  deficits  should  achieve  an  annual  improvement  in  the  cyclically-
adjusted  budget  deficit  of  at  least  0.5%  of  GDP  until  the  'close  to  balance  or  in  surplus'
requirement  is  reached.  It  underlined  the  need  for  automatic  stabilisers  to  operate
symmetrically  over  the  economic  cycle  and  the  particular  importance  of  avoiding  a  pro-
cyclical loosening of fiscal policies in good times. The Council also confirmed the importance
of running down public debt at a satisfactory pace towards the 60% of GDP reference value
and that the existing provisions of  the  Treaty  (i.e. the  debt  criterion  of  the  excessive  deficit
procedure) can contribute to achieving this goal.

An opportunity to ensure consistent and transparent budgetary strategies

To  ensure  that  the  agreement  of  the  European  Council  represents  a  real  progress  towards  a
consistent  and  transparent  implementation  of  SGP,  it  is  essential  that  the  policy  guidelines
endorsed  by  the  European  Council,  and  the  specific  budgetary  commitments  given  by
Member States in their updated stability and convergence programme, are respected.

To this end, policies adopted at national level need to  respect the budgetary goals agreed at
EU  level  In  doing  so,  budgetary  consolidation  strategies  need  to  be  designed  in  a  way  that
tackle,  and  not  exacerbate  structural  weaknesses  leading  to  slow  growth  and  missed
employment  opportunities.  This  requires  careful  design  as  regards  the  balance  between
measures  on  the  revenue  and  expenditure  side,  and  choices  on  the  composition  of  public
expenditures.  Contrary  to  what  is  often  argued,  the  existing  framework  for  budgetary
surveillance  can  simultaneously  achieve  a  consistent  approach  that  balances  the  need  for
budgetary consolidation, re-igniting the recovery and strengthening growth potential.

Significant  advances have been made in the framework for budgetary surveillance

This year’s report on Public finances in EMU –2003 highlights three areas where substantial
progress has been made in the framework for budgetary surveillance over the past year: (i) the
integration  of  candidate  countries  into  the  EU’s  fiscal  surveillance  framework,  (ii)  an
increased  focus  on  the  sustainability  of  public  finances,  and  (iii),  an  improvement  in  the
governance of budgetary statistics. These advances show that tangible progress can be made
to the benefit of Member States and the EU as whole when there is a political will to do so. It
also  shows  that  framework  for  budgetary  surveillance  is  capable  of  evolving  in  light  of
growing experience and new policy challenges.

4

Integrating acceding and candidate countries into the EU’s fiscal surveillance framework

With ten countries set to join the EU in 2004, a major policy challenge is to prepare for their
integration into the EU economic policy framework, in particular for budgetary surveillance.
A key requirement has been to develop reliable government accounts and economic forecasts
on  a  par  with  existing  EU  countries.  At  the  same  time,  the  EU  surveillance  of  budgetary
developments needs to develop so that appropriate account is taken of the important structural
and  institutional  changes  underway  in  accession  countries.  These  are  partly  due  to  the
completion  of  the  transition  from  a  command  to  a  market  economy  and  partly  due  to  the
additional  effects  which  EU  membership  will  entail  (associated  with    the  need  to  upgrade
public infrastructure and the commitment to implement the acquis communautaire).

Clear strides have been  taken  in recent  years,  although  budgetary  data  are  still  neither  fully
comparable across countries nor completely in line with EU definitions. Data reported by the
candidate  countries  and  forecasts  prepared  by  the  Commission  services  indicate  that
budgetary developments are  closely mirroring  those  in  the  EU,  with  nominal  and  cyclically
adjusted budget  deficits in 2002 rising  in most countries.  Looking  ahead  to  2003  and  2004,
the Commission forecast of Spring 2003 envisages an improvement in the budgetary balances
of nine countries, with marked deficit reductions forecasted in Hungary, Slovakia and Turkey,
and  to  a  more  limited  extent  in  Malta.  However,  very  limited  improvements  in  budget
balances are projected in the Czech Republic, Poland and Cyprus.

An important  step  to  integrate  the  candidate  countries  into  the  existing  surveillance  process
was  completed  in  November  2002,  when  the  second  set  of  Pre-accession  Economic
Programmes  (PEPs)  submitted  by  candidate  countries  were  examined.  The  annual
programmes outline the medium-term policy framework, including public finance objectives
and structural reform priorities, and moreover provide an opportunity for candidate countries
to develop their institutional and analytical capacity. The 2002 updates revealed an improved
effort to develop a consistent and credible medium-term macroeconomic framework, although
further analytical capacity building is called for.

The  sustainability  of  public  finances  received  increased  prominence  in  the  assessment  of
sustainability and convergence programmes.

Progress  has  also  been  made  as  regards  placing  increased  emphasis  on  the  sustainability  of
public  finances  in  the  SGP  as  requested  by  the  2001  Stockholm  European  Council.  For  the
second  time,  an  assessment  of  the  sustainability  of  public  finances  was  carried  out  on  the
basis  of  budgetary  targets  and  measures  announced  in  the  2002  updates  to  stability  and
convergence  programmes  leading  to  firm  policy  conclusions  by  the  Council.  The  policy
conclusions,  which  are  based  on  quantitative  indicators  and  long-run  budgetary  projections
prepared by the Economic Policy Committee and national authorities, are worrying.

Even  assuming  all  Member  States  achieve  the  budget  targets  for  2006  set  down  in  their
stability  or  convergence  programmes,  there  is  a  risk  of  unsustainable  public  finances
emerging in about half of EU Member States, especially  Belgium, Germany, Greece, Spain,
France,  Italy,  Austria  and  Portugal.  To  ensure  sustainable  public  finances,  Member  States
with deficits first need to achieve  and sustain the SGP goal  of budget positions of ‘close to
balance or in  surplus’. Furthermore, preliminary  estimates by the  Commission show  that  an
additional permanent budgetary adjustment of between 1 and 2 percentage points of GDP is
needed  in  Member  States  where  the  sustainability  of  public  finances  is  a  concern.  To  close
this financing gap, governments should try to avoid raising taxes (especially on labour), and
concentrate  efforts  on  reducing  (in  terms  of  ratio  to  GDP)  age-related  expenditure  by
reforming  of  pension  and  health  care  systems  and/or  reducing  non-age  related  primary
spending while increasing employment rates and fostering growth.

5

Progress has been made on the governance of budgetary statistics

The  quality  of  economic  statistics  is  crucial  to  ensure  an  adequate  understanding  of  the
economic situation and effective policy making. Budgetary statistics are the foundation of the
EU fiscal surveillance tools and their quality has improved considerably over the last decade.
Government  accounts  are  now  more  reliable,  complete,  transparent  and  detailed,  and  are
published in a much more timely  fashion than when the excessive deficit procedure was set
up. However, some weaknesses remain: in several countries, data on government deficit and
debt  ratios  are  not  yet  as  reliable  as  they  should  be  and  are  subject  to  large  revisions.
Furthermore, the government accounts of several Member States are not fully transparent, and
there  have  been  problems  in  terms  of  their  timely  submission.  These  concerns  are  clearly
amplified with the perspective of enlargement.

To  address  outstanding  challenges,  the  (ECOFIN)  Council  recently  agreed  to  implement  a
code  of  best  practice.4  From  the  Member  States’  side,  this  involves  increasing  the
transparency of  government accounts  in particular for the  lower  government  subsectors,  the
strict respect of deadlines, an overall increase in the data quality, but also a clarification of the
independence statute  of  the  national  statistical  offices  as  the  main  compilers  of  government
data. The Commission (Eurostat) is aiming at reinforcing its ability to scrutinise the Member
States’ government accounts in more detail, and  accelerating the decision making process for
deciding upon the recording of government transactions. The new steps to compile quarterly
budgetary  statistics  is  a  major  challenge  for  statisticians,  but  also  for  economists,  policy-
makers and budgetary policy analysts that will need to interpret quarterly data with due care,
since these will necessarily be more volatile and perhaps less transparent than annual data.

The Commission role in upgrading the analysis of economic and budgetary policies

In  its  Communication  on  strengthening  the  co-ordination  of  budgetary  policies,  the
Commission committed itself to upgrading the analysis of economic  and budgetary policies.
To this end, a number of detailed studies are contained in the report Public finances in EMU –
2003 as follows:

(cid:1)  firstly, the report examines the impact of budgetary consolidation on growth. It considers
whether  the  assertion  that  budgetary  consolidation  has  a  negative  impact  on  output  is
always valid, or whether fiscal consolidations in EMU under certain conditions can have a
positive effect on output;

(cid:1)  secondly,  and  as  part  of  the  effort  to  focus  on  the  quality  of  public  finances,  the  report
analyses  public  investment.  It  examines  the  reasons  why  public  investment  as  share  of
GDP has fallen in recent decades and whether this is in part due the process of budgetary
consolidation  and  the  development  of  fiscal  rules  at  EU  level.  It  also  analyses  the  link
between  public  investment  and  productivity,  and  considers  the  merits  and  feasibility  of
developing  specific  provisions  for  public  investment  within  the  EU’s  framework  for
budgetary surveillance; and,

(cid:1)  a  third  chapter  examines  various  aspects  of  the  challenge  facing  national  authorities  in
ensuring  sound  public  finances.  It  reviews  the  experience  of  Member  States  in  using
expenditures  rules  as  an  instrument  to  better  manage  public  finances  and  improve  their
quality.  In  addition,  the  chapter  examines  how  the  allocation  of  public  finance  functions

4 

Conclusions  of  the  2485th  Council  meeting,  Economic  and  Financial  Affairs,  Brussels  18  February
2003.

6

                                                
across different levels of  governments  influences  the  capacity  of  Member  States  to  fulfil
their budgetary commitments at EU level. This analysis is a good  example of  the role of
the  Commission  in  undertaking  comparative  cross-country  analyses  that  enable  Member
States to learn from the experiences and best practices of other countries.

Is fiscal consolidation always contractionary?

While there is a broad consensus among both academics and policy-makers on  the need  for
fiscal discipline to ensure the smooth functioning of EMU and provide conditions conducive
to  growth  and  employment  creation,  concerns  have  been  expressed  that  budgetary
consolidation could  have  a  negative  effect  on  output  in  the  short  run.  This  issue  is  relevant
given the need for several Member States to reduce large cyclically-adjusted budget deficits,
especially against the current background of slow economic growth.

An empirical analysis of the experiences of EU  Member States,  however,  demonstrates that
roughly half of the episodes of fiscal consolidation undertaken in the past three decades have
been  accompanied  by  an  acceleration  in  economic  growth.  These  findings  appear  to  be
consistent  with  theories  that  identify  a  positive  impact  of  budgetary  consolidation  on
consumer expectations of lower taxes in the future inducing them to raise their consumption
plans,  and/or  on  business  expectations  of  higher  profitability  enabling  them  to  raise
investment. Confidence factors may play a more prominent role in the future in light of large
unfunded pension liabilities.

Simulations  using  the  QUEST  model  confirm  that  if  appropriately  designed,  budgetary
consolidation  can  contribute  significantly  to  the  goal  of  Lisbon  strategy  in  terms  of  raising
output  and  employment  in  the  medium-term.  Budgetary  consolidation  have  a  slight
contractionary  effect  on  output  in  the  short  run,  depending  on  the  composition  of  the
budgetary  adjustment. However, budgetary  consolidation has  a positive  impact on output in
the  medium-run  if  it  takes  place  in  the  form  of  expenditure  retrenchment  rather  than  tax
increases. Moreover, the effect of budgetary consolidation on output could be reinforced, and
even  positive,  in  the  short-run  if  fiscal  consolidation  is  combined  with  structural  reform  of
factor  and  product  markets  and  accompanied  with  an  accommodating  monetary  stance.
Indeed, budgetary consolidation often acts as a catalyst for structural reforms.

Public investment

Public  investment  as  a  share  of  GDP  has  fallen  in  most  industrialised  countries  in  recent
decades. It has been claimed that the budgetary requirements of the Treaty and SGP result in
public investment expenditures being at excessively low levels, and that a sustained growth in
public  investment  expenditures  would  improve  the  EU’s  growth  potential.  However,  an
analysis shows that the decline in public investment rates is a long-run tendency that started
already in the 1970’s, and affected all industrialised countries and not just EU Member States.
Declining levels of public investment as a share of GDP have been attributed to factors such
as increased levels of economic development (with developed countries already having a high
stock of physical capital and the emphasis switching towards investment in  human  capital5)
and  the  changing  boundaries  between  public  and  private  investment  (in  part  linked  to  the
process of privatisation). Some of the decline in public investment levels appears to be related
to efforts to consolidate public finances, which was necessary irrespective of EMU. A careful
analysis of the data, however, fails to show any clear-cut link between change in investment

5 

Communication  from  the  Commission  ‘Investing  efficiently  in  education  and  training:  an  imperative
for Europe”, COM(2002)779

7

                                                
ratios  and  the  provisions  of  the  EU’s  framework  for  fiscal  surveillance.  Indeed  public
investment expenditures in many Member States have stopped falling after the beginning of
monetary union.

Public  investment  can  make  an  important  contribution  to  meet  the  output  and  employment
goals  of  the  Lisbon  strategy.  However,  in  considering  the  links  between  public  investment
and growth, it is important to focus on net as opposed to gross investment levels (i.e. taking
account  of  the  depreciation  of  the  existing  capital  stock)  and  also  the  interaction  between
trends  in  public  and  private  investment  level.  Existing  studies  reveal  that  public  investment
has a positive impact on output and productivity, although the results are not very strong. This
is explained by the fact that only a fraction of public investment expenditures are devoted to
projects which aim at directly raising productivity (e.g. investment in transport infrastructure),
whereas a significant proportion of public investment is devoted to projects that pursue other
objectives  such  as  environmental  protection  or  redistribution  across  regions,  which  have  an
indirect contribution to productivity .

The important role of public investment is recognised in the existing framework for budgetary
surveillance: for example, Member  States are required to specify planned  public investment
levels  in  their  annual  updates  to  stability  and  convergence  programmes  and  the  BEPGs
frequently recommend that an increased share of public expenditures be devoted to productive
items. In brief, the budget balance requirements of Treaty and SGP are compatible with a high
share  of  public  spending  being  devoted  to  public  investment.  The  recent  Commission
Communication  on  strengthening  the  co-ordination  of  budgetary  polices  sought  to  cater  for
the  budgetary  impact  of  large  investment  projects  while  at  the  same  time  respecting  the
commitment to sound and sustainable public finances6.

Several calls have been made to introduce a so-called golden rule into the SGP, which would
allow governments to borrow to finance investment. However, there are strong theoretical and
practical  arguments  against  its  introduction,  especially  in  a  framework  of  multilateral
surveillance such as the SGP. First, a golden rule based on a national accounts system could
lead to a bias in expenditure decisions in favour of physical capital and against spending on
human capital (education, training) or other productive items (health care, R&D) which also
contribute to growth  and employment. Secondly, if applied to gross investment, depending on
the specific design and implementation of the reform,  the  adoption  of  a  golden rule into the
SGP framework may imply substantially higher deficits, thus compromising the objective of
sustainability of public finances. Finally, the relevant concept for the application of the golden
rule  would  be  net  investment.  However,  it  is  not  always  possible  to  compute  reliable,
comparable and timely data on this type of investment.

There is a growing practice of financing public purpose investment projects through public-
private  partnerships  (PPPs).  A  large  share  of  the  PPPs  in  the  EU  finance  infrastructure  and
supplement public investment.7 The main implication for public finances of choosing PPPs as
opposed  to  traditional  public  investment  is  in  fact  that  of  converting  up-front  fixed
expenditures  into  a  stream  of  future  obligations.  This  practice  has  a  sound  microeconomic
rationale in that it can lead to increased efficiency without compromising public objectives. It
is important however to avoid recourse to PPPs where this is solely motivated by a desire to
bypass budgetary constraints.  by putting capital spending outside government budgets. This

6 

7 

The  Council  has  shown  some  flexibility  in  interpreting  compliance  with  the  “close  to  balance  or  in
surplus” requirement to reflect significant planned increases in public investment programmes.
Also  see  Communication  from  the  Commission    “Developing  the  trans-European  transport  network:
innovative funding solutions : interoperatibility of electronic toll collection systems”, COM(2003)132
of 24 April 2003.

8

                                                
could lead to PPP projects which entail higher overall costs, which would not be in line with
the objective of sustainable public finances. Efforts are also required to ensure transparency in
national accounts.

Efforts at national level to meet EU budgetary requirements: expenditure rules and fiscal
relations across different levels of governments

Many Member States in recent years have introduced expenditure rules as a means to improve
the  management  of  their  public  finances,  mostly  in  the  form  of  ex-ante  targets  rather  than
binding  legal obligations.  National expenditure  rules  can  enable  Member  States  to  meet  the
budget  balance  requirements  of  the  Treaty  and  SGP  by  helping  them  to  better  control
expenditure  items  that  are  subject  to  overruns.  The  specific  design  and  the  strength  of  the
enforcement mechanisms are key to their effectiveness. Depending on their design, they can
also contribute to other policy objectives such as avoiding a pro-cyclical loosening of  fiscal
policy in good times, and improving the quality of the composition of public spending.

There is a great deal of variety in the design of expenditure rules across EU Member States, as
regards  the  the  types  of  expenditure  covered  by  a  rule,  the  time  frame  involved  and  the
robustness  of  surveillance  and  enforcement  mechanisms.  Preliminary  empirical  analysis
indicates that the existing expenditure rules have not had a visible impact on trends in public
spending. However, judging compliance with expenditure rules is difficult as in many cases
they cover several years and are subject to revisions. In some countries, expenditure rules are
not ambitious enough and adherence with them is easily reached: in other cases, the rule has
been adjusted or abandoned if it is perceived as being too ambitious. Overall, even a relatively
weak  expenditure  rule  can  provide  useful  guidance  and  signals  to  actors  involved  in  the
budgetary process.

The Treaty and SGP requirements are defined in terms of the budget balance of the  general
government  (i.e.  central  and  local/state  governments  and  social  security),  although  the
specific  budget  targets  in  stability  and  convergence  programmes  are  set  by  the  central
government. The challenge in meeting EU budgetary requirements is therefore affected by the
way in which Member States allocate fiscal functions (both revenues and expenditures) across
different levels of government. This is especially the case in federal countries and the Member
States  where  local  authorities  have  considerable  budgetary  autonomy.  The  contribution  of
sub-central authorities to the overall budget position is changing in a number of countries  in
light of efforts to devolve certain public functions to regional/local authorities.

The  direct  contribution  of  lower  levels  of  government  to  the  general  government  deficit  is
generally limited since all Member States apply restrictions to local government borrowing:
the exception is Germany, where net borrowing by local and state governments accounts for
nearly half of the general government budget deficit in 2002. However, it should be borne in
mind that de facto central government often have to bear the cost of financing difficulties that
emerge  at sub-central  level.  To  help  comply  with  the  EU's  fiscal  rules,  the  federal  Member
States and Italy and Spain have recently introduced arrangements that aim at co-ordinating the
budgetary position across levels of government (usually referred to as national stability pacts).
More experience with the implementation of these arrangements is needed before conclusions
can  be  drawn  on  their  effectiveness  in  contributing  to  the  objectives  of  the  EU  fiscal
framework. A priori, a  strong legal  base and enforcement mechanism  would be  expected to
contribute to the credibility and effectiveness of the arrangements.

The  process  of  decentralising  responsibility  for  some  policies  raises  a  second  issue  in  the
context  of  EMU,  namely  the  operation  of  automatic  stabilisers.  Experience  shows  that  in

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general  systems  are  designed  to  shield  sub-national  governments  from  cyclical  variations.
However, empirical evidence for the US and Germany suggests some degree of pro-cyclical
behaviour at the level of the States. Further research would be useful to analyse the possible
interaction between fiscal decentralisation and automatic stabilisation and to identify the best
practices  to  reconcile  the  process  of  decentralisation  with  ensuring  sound  and  sustainable
public finances

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