# **V. How to mitigate the procyclicality bias: Policy options budget composition, decentralization, and fiscal rules**

# **_Top-down solution: Fiscal rules_**

This section explores the correlation between the procyclical bias and the existence of fiscal rules and some of their features.<sup>13</sup> National fiscal rules are generally recognized to be more effective than supranational fiscal rules (Tapsoba, 2012). Indeed, supranational rules generally suffer from a problem of insufficient enforcement and compliance. Fiscal rules (FRs) are often criticized to amplify the procyclical bias,<sup>14</sup> but Guerguil et al. (2016) suggest that the design of the rules matters. Based on the fiscal rules data set from the Fiscal Affairs Department, we consider several characteristics of the national FRs, namely (i) if a fiscal council also exists; (ii) the presence of effective monitoring mechanisms; (iii) the presence of effective enforcement mechanisms; (iv) the coverage of general government for the rules; (v) the existence of a written legal basis for the rules (statutory or constitutional); (vi) the presence of escape clauses; and (vii) the presence of other kind of flexibility - investment-friendly rules and cyclically-adjusted rules (see Guerguil et al., 2016). The comparison of the procyclicality bias between countries with and without these features shows (Table C.1 and Figure C.3) that countries with national FRs have a lower procyclical bias, though still positive. The other characteristics that show statistically significant differences are (i) fiscal councils; (ii) monitoring mechanisms; (iii) enforcement mechanisms; (iv) a written legal basis; (v) the presence of escape clauses, and (vi) flexibility features are associated with less procyclicality than non-FR countries, highlighting the relevance of adequate design of national FRs to mitigate procyclicality.

# **[insert Table C.1 and Figure C.1]**

# **_Top-down solution: Fiscal councils_**

The other potential top-down solution we explore is another fiscal institution, namely the fiscal councils. Fiscal councils (FCs) are defined as independent, non-partisan agencies with an official mandate to assess fiscal policies, plans, rules, and performance (Debrun et al., 2013). They do not have a direct role in setting policy instruments, but they can influence fiscal behavior through three main channels. First, by fostering transparency of fiscal policy, an FC might reduce the rationale for voters to “starve the Leviathan.” Second, they can increase the reputational costs for politicians on unsound policies and broken commitments. Third, they can provide direct inputs to the budget process, with forecasts or assessments of structural positions; as suggested in the previous paragraph they can close technical loopholes that allow governments to circumvent numerical fiscal rules (Debrun et al., 2017). Taking advantage of the FC data set from the Fiscal Affairs Department, we check (i) whether the FC

> 13 We account for numerical fiscal rules. For a literature review on procedural rules, see Alesina and Perotti (1999). 14 On procyclical bias, a petition signed by 1,100 economists and 11 Nobel economists in the New York Times claimed that attempts to strictly keep the budget balance (in US states) would aggravate recession (see Levinson, 1998).

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