Updating the EU’s fiscal rules (Part 2)

Meeting the EU’s high public investment needs for the green and just transition requires sound economic policy and a fiscal framework that enables Member States to increase investment without risking government default. Considering the weaknesses of the current EU fiscal framework in terms of low fiscal flexibility and procyclicality, an expenditure rule is currently discussed as a potential remedy. Designed in the right way, an expenditure rule can enable countercyclical fiscal policy with increased fiscal space. To decouple the expenditure rule from GDP-based estimates, this paper presents alternative indices that measure Member States’ performance in terms of the green and just transition better than GDP does and has assessed how they can be applied as a benchmark for the expenditure rule.

All presented scenarios show some limitations with respect to observability, incentives, and cyclicality. Also, all indices, apart from indices that still incorporate GDP, don’t address core GDP dependencies. A shrinking GDP will lead to increased government bond risk premiums because financial market actors use GDP for their assessments – no matter which index a government uses to assess their fiscal space. Therefore, it’s not feasible for governments to ignore GDP in their fiscal space calculations under these circumstances. The same holds true for other GDP dependencies.

Although the option of applying a GDP-adjusting index as a performance gap benchmark can partially mitigate these issues, the strong reliance on GDP prevents addressing the drawbacks of using GDP as a performance index altogether. The study therefore reveals a gap by demonstrating that there is not yet an alternative to GDP that is feasible to implement as an alternative benchmark for assessing fiscal space and that steers the EU towards achieving the objectives of the European Green Deal and enabling a green and just transition.