Public finances in EMU – 2007. Ensuring the effectiveness of the preventive arm of the SGP

Compared to a couple of years ago, the overall conditions of public finances have improved significantly in 2006 in both the euro area and the EU as a whole. This year the Public Finances in EMU report focuses on ways to keep up the momentum of fiscal adjustment so as to make rapid progress towards the achievement of sustainable fiscal positions.

The current situation supports the conclusion that following the reform of the Stability and Growth Pact (SGP) in 2005, the corrective arm of the Pact has re-gained credibility. Countries with an excessive deficit have made substantial progress and based on current plans, all but two of these countries will have brought the deficit below the 3% of GDP threshold of the Treaty by the end of 2008. However, concerns remain as to whether the positive momentum of fiscal adjustment is maintained beyond the correction of excessive deficits so as to prepare for the impending budgetary impact of ageing populations.

In 2006, the better-than-expected budgetary outturn in the euro area and the EU as a whole was primarily driven by important positive surprises in tax revenues, a part of which is likely to be temporary. In some countries these windfalls were used to finance higher-than-planned expenditure and some Member States are planning to take advantage of higher-than-expected revenues to cut taxes. Overall, the budgetary plans of countries currently not in excessive deficit and those relating to the period after the correction of an excessive deficit are not particularly ambitious and not in line with the requirements of the Pact.

Against this background, the main challenge in the coming years is to ensure a better operation of the preventive arm of the SGP. In particular, the objective is to fully take advantage of currently economic good times to accelerate the convergence towards sustainable fiscal positions. This year's report reviews and examines a number of areas where progress may help achieve this objective.

The report also includes two analytical parts focusing on key topics in the current debate.

How to stick to medium-term budgetary plans? In the past, a number of EU countries faced recurrent difficulties in respecting the medium-term budgetary targets set in their Stability and Convergence Programmes. This year's Public Finance Report looks at the factors which explain why some countries were able to stick to targets better than others. When comparing plans with outcomes in the period 1998 through 2006, in about two thirds of the cases the improvement in the government balance was lower than targeted. Difficulties in the implementation of medium-term expenditure plans turn out to be the main cause of the slippages. The analysis also highlights a number of regularities. Firstly, it is easier to meet budgetary targets at the beginning of a consolidation process when the potential for cutting expenditure is relatively large. Secondly, expenditure overruns seem to be independent of macroeconomic developments. The frequency and size of expenditure overruns were similar in periods of higher or lower-than-expected economic growth. Finally - and this can be considered the most important result of the analysis - there is a clear link between the quality of national medium-term budgetary frameworks and the capacity to achieve multi-annual expenditure targets.

Lessons from successful fiscal consolidations. Over the past decades, most EU countries underwent successive episodes of fiscal consolidation. Some gave rise to a more lasting correction of public finances, while others were immediately reversed. This year's Public Finance Report reviews the evidence on fiscal consolidation in the EU since the 1970. The main aim is to shed light on the factors that determine the success of fiscal corrections. The analysis highlights a number of important lessons for the coming years. To start with, the work confirms the role played by the composition of adjustment: expenditure-based adjustments, especially those centred on primary current expenditure, are more likely to be successful than those that mainly rely on higher revenues. Large cuts on investment expenditure are not conducive to success, as they generally tend to be short-lived. The analysis also suggests that fiscal consolidations tend to produce a more lasting correction of the budget balance if (i) they are accompanied by structural reforms and (ii) they are covered by effective fiscal rules and effective budgetary procedures.

Individual chapters
Part I: Current developments and prospects
Part II: Evolving budgetary surveillance
Part III: How to stick to medium-term budgetary plans?
Part IV: Lessons from successful fiscal consolidations
Part V: Member States developments
Part VI: Resources.