Ensuring the effectiveness of the preventive arm of the Stability and Growth Pact: Public Finances in EMU - 2007

The European Commission is concerned about the implementation of the preventive arm of the Stability and Growth Pact, given that certain Member States not yet at their medium-term target appear to be making insufficient fiscal consolidation efforts in an environment of favourable cyclical conditions. Whilst emphasizing the satisfactory implementation of excessive deficit procedures, the Commission puts forward concrete proposals for strengthening the preventive arm of the Stability and Growth Pact.

ACT

Commission Communication of 13 June 2007 to the Council and the European Parliament: Public Finances in EMU - 2007. Ensuring the effectiveness of the preventive arm of the Stability and Growth Pact [COM (2007) 316 - Not published in the Official Journal].

SUMMARY

In this Communication the European Commission sets out concrete proposals for strengthening the preventive arm of the Stability and Growth Pact, based on the 2005 Stability and Growth Pact reform. It reviews recent budgetary developments and the functioning of the European Union (EU) fiscal framework. Whilst emphasizing the smooth implementation of excessive deficit procedures, the Commission also notes some deviations from the rules of the preventive arm of the Pact.

Political commitment required to address the challenges of the preventive arm

As it essentially focuses on medium-term planning, the preventive arm requires peer support and the sharing of best practices. Moreover, in order to function effectively, it requires a common understanding of the economic and fiscal policy challenges in the European Union, and a strong political commitment to addressing them.

Gradual improvement in public finances

Public finances continued to improve in 2006 in the European Union and in the euro zone. Against a background of favourable economic conditions, the EU public sector deficit fell from 2.4% of gross domestic product (GDP) in 2005 to 1.7% in 2006. The debt ratio recorded its first decline since 2002 in both the EU and the euro zone. Overall, the budgetary situation was characterised by a significant reduction in the EU structural deficit from nearly 3% of GDP in 2004 to less than 1.5% in 2006, according to the Commission.

Nevertheless, whether such fiscal consolidation is permanent in nature may be called into question in the light of a faster than anticipated increase in government expenditure in a number of EU countries.

Avoid repeating past mistakes

The Commission is anxious for past economic policy mistakes not to be repeated, as in some cases the Member States have used tax windfalls to finance increases in government expenditure. The current background of sustained economic growth and higher than anticipated tax revenues closely resembles the situation that prevailed at the turn of the decade, a period during which economic policy mistakes were made. During the years 1999-2001 several Member States failed to make use of good economic conditions to consolidate their public finances. These countries subsequently found themselves in an uncomfortable position when the cycle entered a less favourable phase.

The Commission emphasizes that it is crucial to maintain the pace of fiscal consolidation during the current phase of good economic conditions.

Fewer excessive deficits, greater fiscal consolidation concerns

The Stability and Growth Pact reform has improved the functioning of the excessive deficit procedure. Countries with excessive deficits have appropriately used the deadlines for the correction of excessive deficits established under the reformed Pact and made significant structural efforts to correct the situation. Whereas ten Member States still had deficits greater than 3% of GDP in 2004, in 2008 only Hungary and the Czech Republic will still be in this situation on the basis of the plans contained in the latest updates of the stability and convergence programmes.

Nevertheless, based on past experience and future prospects the Commission has concerns regarding the functioning of the preventive arm of the Stability and Growth Pact. In 2006, the fiscal consolidation efforts of some Member States not yet at their medium-term target were insufficient given the improving cyclical conditions. Furthermore, the Commission has expressed its disappointment with the budgetary plans submitted. In some euro zone and ERM-II countries, the forecast improvement in the structural balance for 2007 and subsequent years falls short of the 0.5% of GDP benchmark provided for in the revised Pact, contrary to Council recommendations, and despite economic conditions that would justify exceeding it.

If nothing changes, the Commission reckons that only ten of the twenty-seven EU countries will have reached their medium-term target in 2008, after two consecutive years of above-trend growth.

In this Communication the Commission puts forward proposals to increase the effectiveness of the preventive arm of the Stability and Growth Pact. This would enable progress to be made towards the goal of sustainable public finances.

Prevention ensures sustainable public finances

Taking the best practices of EU countries as a basis, the Commission draws up concrete proposals for improving the preventive arm of the Pact. These proposals may be implemented within the framework of current legislation. They are centred on four main themes:

• Setting fiscal policy issues within a broader economic perspective. The stability and convergence programmes and the Commission's assessment could place greater emphasis on the quality and effectiveness of public finances and strengthen their links to the national reform programmes under the Lisbon Strategy. The Member States could also provide information on fiscal institution reform undertaken with a view to improving the quality and effectiveness of public finances. Furthermore, the Member States and the Commission could take the macroeconomic situation of each country into consideration to a greater extent when assessing national fiscal policies, and pay particular attention to the development of external imbalances, inflation and competitiveness.
• Enhancing the national ownership of medium-term budgetary targets set in the stability and convergence programmes. In order to better adhere to their medium-term budget plan targets, the Member States should strengthen the commitment of all those involved in managing fiscal policy at national level to following policies which are consistent with those targets.
• Strengthening the reliability and credibility of medium-term budgetary plans. The Member States could indicate more clearly in their stability and convergence programmes whether the medium-term targets can be reached if policies remain unchanged or whether additional measures are necessary. It would also be important to indicate the gap between budgetary targets and the development of public finances, and to set out in detail the measures envisaged for closing that gap. This would contribute to the reliability and credibility of the medium-term budgetary targets.
• Moving towards viable medium-term budgetary positions. As provided for in the 2005 Stability and Growth Pact reform, the Commission and the Member States will step up their efforts to further develop the links between medium-term fiscal policies and long-term budgetary dynamics. The Commission will analyse compliance with past budgetary targets, with a particular emphasis on the development of government expenditure.

The European Commission will discuss the above proposals with the Member States.

Last updated: 03.07.2007