Public finances in Member States in 2005

The Commission is taking stock of public finances in Member States. This communication focuses on the reform of the stability and growth pact that took place during 2005.

ACT

Communication from the Commission to the Council and the European Parliament of 1 June 2005: "Public finances in EMU - 2005" [COM(2005) 231 final - Not published in the Official Journal].

SUMMARY

The communication summarises the main policy messages of the report entitled " Public finances in EMU - 2005 ", the latest of the reports the Commission has drawn up each year since 2000. The Commission notes that there are still budgetary imbalances in some countries (Germany, Cyprus, France, Greece, Hungary, Italy, Malta, Poland, Slovakia and United Kingdom), although the general government deficit in the euro area has improved marginally. According to forecasts, the euro-area and EU deficits should remain roughly stable in 2005 and 2006.

Ten Member States face excessive deficit procedures

The communication takes account of the reform of the stability and growth pact (SGP). Since the summer of 2004, ten EU countries have been subject to the excessive deficit procedure (EDP):

• France and Germany. Following the Court of Justice ruling *, both countries have taken measures that could result in the excessive deficit being corrected in 2005. At this stage no further action under the EDP is necessary.
• Netherlands. The Netherlands reduced their excessive deficit to 2.5 % of gross domestic product (GDP) in 2004. The Commission therefore proposed in May 2005 to abrogate the decision on the existence of an excessive deficit.
• Cyprus, Hungary, Malta, Poland, Czech Republic and Slovakia. The Council decided that an excessive deficit existed in each of these countries outside the euro area. In order to remedy the situation, it issued recommendations to these countries. All of them, apart from Hungary, have taken effective measures in response to the recommendation.
• Greece. The Council has issued a notice to Greece, the last step before sanctions. Greece has until 2006 to correct the excessive deficit, which is of an unprecedented magnitude (5.2 % and 6.1 % of GDP in 2003 and 2004 respectively).

The Commission is placing emphasis on improving statistical governance in the budgetary field following the revision in the Greek government accounts in 2004. In a communication on a European governance strategy for fiscal statistics [COM(2004) 832 final], the Commission put forward three lines of action:

• building up the legislative framework;
• developing the Commission's operational capacity;
• defining European standards on the independence of statistical institutes.

Reform of the stability and growth pact: analysing budgetary data

The communication describes the main stages of the reform of the stability and growth pact. The debate has led to changes in the basic regulations on the surveillance of budgetary positions and the implementation of the excessive deficit procedure.

The Commission notes that the report aims to improve the understanding of public finance issues in the EU and to upgrade budgetary surveillance. For 2005, the report presents an analysis of the discrepancy between budgetary plans presented in stability and convergence programmes and the actual results achieved, an analysis of the determinants of debt dynamics and an analysis of the long-term sustainability of public finances.

These analyses enable the Commission to:

• achieve effective budgetary planning. The Commission has collected data enabling it to compare actual budgetary developments in the Member States with initial objectives. In this way it has been able to see how its assessment of stability and convergence programmes has evolved over the years. It highlights the importance of finding ways to avoid spending slippages and more effectively plan expenditure patterns in a manner that increases their quality - also to better match the new Lisbon priorities.
• understand the determinants of debt dynamics. The Commission focuses on "stock-flow adjustment", which captures the residual discrepancy between the change in the outstanding debt stock and the general government deficit, as defined in the Protocol to the Maastricht Treaty. The usual analysis focuses on deficits and nominal growth, while much less attention has been given to the stock-flow adjustment. However, this component conveys relevant information about the evolution of government assets and liabilities and about the discrepancy between deficits. The report shows that the stock-flow adjustment in past years has, on average, been positive (consequently adding to the build-up of debt) and that in some countries it is partly associated with cash deficits being systematically higher than "Maastricht deficits".
• increase focus on the long-term sustainability of public finances. Public finances must be sustainable, despite ageing populations and the costs involved in the European social model. The 2005 report shows that the Member States must consolidate their budgets in order to achieve a sustainable position. The reform of the stability and growth pact is helping to ensure the long-term sustainability of public finances. The exchange of information among Member States and with the Commission on national expenditure will increase transparency and lead to a better assessment of the long-term sustainability of public finances.

Structural reforms and budgetary objectives

The Commission gives high priority to economic reforms that increase growth and employment. The report reviews and discusses the link between the implementation of structural reforms and budgets in implementing the EU framework for fiscal policy. This important issue has been under-researched.

Reforms can contain the growth of certain types of government expenditure, such as reforms of pension or health care systems. Reforms aimed at improving potential output and growth may also have indirect positive effects. However, numerical rules to limit excessive deficits may discourage reforms. The trade-off between reforms and budgetary objectives can be explained by the short-term costs of reforms and by the fact that reforms can be costly to particular groups in society, so that tax cuts or other government transfers may be needed.

The report looks at labour and product market reforms and pension reforms. The analysis focuses on two issues: the short-term impact of reforms on budgets, and the possibility that fiscal consolidation measures prevent reforms. According to the data, there is no strong evidence to show that reforms are less frequent in times of budgetary consolidation. However, in the aftermath of reforms there is, in general, a slight deterioration in budget balances. The Commission believes that reforms should be considered with caution in the implementation of the stability and growth pact (SGP). The 2005 SGP reform package includes provisions aimed at ensuring that the budgetary objectives of the EU fiscal framework do not clash with structural reforms that may contribute to sound public finances and increased growth.

New Member States: fiscal challenges

The ten Member States that joined the EU in 2004 are continuing their economic integration by catching up in terms of their income levels and by looking forward to adopting the euro. Fiscal policy can make a key contribution in this process via efficient and sustainable tax and expenditure policies and by supporting stable development of the economy. In the short term, some of the new Member States may need to make difficult choices, for example on higher spending in certain areas such as infrastructure, training or R&D, which may make it even harder to contain budget deficits. The report discusses the main challenges facing the new Member States in conducting their fiscal policy, such as the problem of an ageing population.

The new Member States are in a position to finance some of their needs thanks to their high potential growth and, in some cases, their low public debt. However, the stock of contingent liabilities is relatively high in many of these countries, and this creates the risk of sudden upswings in debt levels if government payments related to guarantees materialise. The Commission highlights the importance of taking advantage of periods of strong growth to achieve budgetary improvements. In this way, Member States can ensure adequate headroom to stabilise the economy during a downturn.

The Commission believes that there is scope for policy-makers in the new Member States to pursue their growth and stability objectives while ensuring proper management of public finances. Efforts must be made to:

• restructure existing expenditure programmes;
• enhance tax bases in order to strengthen public finances and foster conditions conducive to growth;
• enhance the transparency of budgetary procedures;
• improve risk management in the private sector via well-designed surveillance.

Although the framework for economic and budgetary surveillance in EMU has provided positive results, analyses show that Member States need to do more if they are to deliver the expected results. The reform of the SGP and the Lisbon strategy have responded to the need to match procedural rules with the economic reality and needs of the Member States. They will be tested in the years to come. The way the new SGP framework will be implemented from the start will be crucial for its future credibility. The Commission encourages the Member States to pursue this ambitious strategy by enhancing the quality and ensuring the sustainability of their public finances.

See also

For further information, see the website of the Directorate-General for Economic and Financial Affairs:

• Public finances in the European Union: reports from 2000.

Last updated: 19.12.2005