Do fiscal rules constrain political budget cycles?

Public Choice https://doi.org/10.1007/s11127-020-00797-3 Do fiscal rules constrain political budget cycles? Bram Gootjes1 · Jakob de Haan1,2,3 · Richard Jong‑A‑Pin1,3 Received: 5 May 2019 / Accepted: 7 March 2020 © The Author(s) 2020 Abstract We ask whether fiscal rules constrain incumbents from using fiscal policy tools for reelection purposes. Using data on fiscal rules provided by the IMF for a sample of 77 (advanced and developing) countries over the 1984–2015 period, we find that strong fiscal rules dampen political budget cycles. Our results are remarkably robust against inclusion of media freedom and the level of government debt as explanatory variables. Furthermore, we find a strong effect of fiscal rules in, amongst others, countries with fewer veto players, left-wing governments, established democracies, and more globalized economies. In addition, the effect of fiscal rules on political budget cycles seems to be stronger after the global financial crisis, reflecting post-crisis expansion in the number of countries with strong fiscal rules, notably in the European Union. Keywords Political budget cycles · Fiscal policy · Fiscal rules JEL Classification E62 · H62 1 Introduction The political budget cycle (PBC) literature focuses on election cycles in government spending, taxation and budget deficits. Early PBC models were based on the premise that incumbents manipulate fiscal policy in order to secure reelection and predicted that governments adopt expansionary fiscal policies before Election Day (Nordhaus 1975). More recent PBC models emphasize the role of temporary informational asymmetries regarding politicians’ competencies in explaining electoral cycles in fiscal policy. In those models, signaling competency is the driving force behind the PBC (see, for example, Shi and Electronic supplementary material The online version of this article (https://doi.org/10.1007/s1112 7-020-00797-3) contains supplementary material, which is available to authorized users. * Bram Gootjes 1 University of Groningen, Groningen, The Netherlands 2 De Nederlandsche Bank, Amsterdam, The Netherlands 3 CESifo, Munich, Germany 13 Vol.:(0123456789) Public Choice Svensson 2006).1 Although the evidence is mixed, several studies report evidence for election effects in fiscal policy.2 Recent research no longer assumes that all governments will behave in the same way, but asks under what circumstances a PBC is more likely to occur (de Haan and Klomp 2013). The more private benefits politicians gain when in power (i.e., larger rents from remaining in public office), the stronger are their incentives to influence voters’ perceptions prior to an election. Incumbents’ ability to manipulate government finances is shaped by a number of different constraints on their behavior.3 Recently, Veiga et al. (2017) examined circumstances under which fiscal manipulation may occur, differentiating between several factors affecting the incentives of the incumbent to behave opportunistically, factors affecting the capacity of the opportunistic policies to yield additional votes,4 and characteristics of political institutions, such as proportional versus majoritarian electoral rules. They find that the degree of media freedom is the most important conditioning factor for PBCs. When media freedom is weak, the electoral effect on budget deficits is strong. However, Veiga et al. (2017) do not consider whether fiscal rules, i.e., long-lasting constraints on fiscal policy in the form of numerical limits on budgetary aggregates (Schaechter et al. 2012), condition PBCs. It is likely that incumbents constrained by such rules will have a more difficult time increasing spending or cutting taxes before elections. As Alt and Rose (2007, p. 862) in their analysis of fiscal rules in US states write, “we should observe larger cycles in states without fiscal rules than in those with rules if these rules are effective in limiting politicians’ ability to run deficits and thus manipulate the timing of spending for electoral purposes.” And that indeed is what they find. In explaining the result, Alt and Rose refer to the signal-extraction problem faced by financial markets, i.e., how to discern the true state of affairs from the available information. Lowry and Alt (2001) argue that balanced budget requirements allow bond market participants to solve precisely such a signalextraction problem, thereby making it easier for imperfectly informed bond market investors to distinguish between political officials who choose to comply with balanced budgets and those who do not. Alt and Rose (2007, p. 863) argue that “if politicians in states with no-carry rules run consecutive deficits, investors interpret their behavior as opportunism and respond sharply.” Fiscal rules therefore may narrow the government’s room for fiscal maneuvering, thereby limiting the incumbent’s capacity to behave opportunistically. 1 Not all theoretical PBC models are based on signaling competency. For instance, Drazen and Eslava (2010) develop a model in which politicians differ in the values they assign to different types of spending, but voters do not observe those preferences. By shifting the composition of spending towards the goods voters prefer, an incumbent politician will try to signal that his preferences are close to those of voters, implying that he will choose high post-election spending on those same goods. The evidence of Drazen and Eslava (2010) and some other studies discussed in de Haan and Klomp (2013) provide support for that mechanism. 2 See Dubois (2016) for a recent review of the literature; Mandon and Cazals (2019) and Philips (2016) report evidence from meta-analyses of the PBC literature. 3 Conditioning factors discussed in the literature include the transparency of budget institutions (Alt and Lassen 2006a, b), the age of democracy (Brender and Drazen 2005, 2013), political checks and balances (Streb et al. 2009) and media freedom or quality (Shi and Svensson 2006; Veiga et al. 2017; Repetto 2018). 4 As to the capacity, contrary to the standard assumption in PBC models that expansionary fiscal policies will strengthen electoral support for the incumbent, Peltzman (1992) argues that US voters punish politicians who let government spending increase, no matter whether that increase is financed by taxes or debt. Brender and Drazen (2008) report similar findings for a sample of 74 countries. However, focusing on support for the political parties in government instead of the prime minister’s party, Klomp and de Haan (2013) report that expansionary fiscal policies increase electoral support for incumbents. 13 Public Choice On the other hand, strict fiscal rules may encourage incumbents to circumvent the rules, making use of creative accounting practices (Milesi-Ferretti 2004). Some evidence supports that view. For instance, focusing on member states of the European Economic and Monetary Union (EMU), Alt et al. (2014) report (...truncated)