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National Audit Office’s Annual Report to Parliament 2020

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Uncertainty of forecasts should be taken into account in the pursuit of balanced general government finances

Fiscal policy legislation requires the Government to pursue balanced general government finances. However, it also provides flexibility under exceptional circumstances such as the coronavirus crisis. When measures to promote the balance are planned, it should be taken into account that budgetary forecasts are uncertain even under normal circumstances. The impact of the measures taken should also be assessed regularly during the government term. Fiscal policy should not be based directly on sustainability assessments, but they are useful when the need for structural reforms is considered. Sustainability analyses should be expanded, and this should be supported by legislative amendments.

The setting of fiscal policy objectives is steered in Finland by both the EU framework adopted after the financial crisis and the domestic legislation developed according to the EU rules. The Government presents its statutory fiscal policy objectives annually in the General Government Fiscal Plan submitted to Parliament.

The Government is not free to select the fiscal policy objectives set out in the General Government Fiscal Plan or their strictness.

The main objective relates to the structural balance of general government finances, i.e. central government, local government, employment pension institutions, and other social security funds. The general government structural balance reflects the difference between general government revenue and expenditure net of the effects of the economic cycle and certain one-off factors. The EU framework sets a minimum level for the structural balance objective, and the Finnish Government cannot set a less strict objective (see Figure 1). From the beginning of the present regulation, the minimum level in Finland has been −0.5 per cent of GDP.

Fiscal policy regulation steers the Government to seek a balance

Under domestic legislation, the Government is also required to set an objective for the general government nominal balance in the General Government Fiscal Plan. Unlike in the case of structural balance, the effects of the economic cycle and one-off factors are not eliminated from it. Under normal economic circumstances, the nominal balance objective leads to achieving at least the structural balance objective, which provides the Government with hardly any room for manoeuvre. In Finland, Governments have set balanced general government finances as the nominal balance objective . This has been justified, as it leaves a small safety margin between the nominal and structural target.

The Government may become obliged to strengthen general government finances based on an ex-post EU decision.

If the nominal balance objective is not achieved, the Government has no statutory obligation to remedy the situation. The correction mechanism, which obliges the Government to take fiscal policy measures to achieve a balance, can only be activated later following a significant deviation from the structural balance objective.

The mechanism is based on EU-level decisions, and therefore many exceptional circumstances are taken into account automatically. Because of the coronavirus crisis, for example, the EU decided that during the crisis, Member States did not have to strive to achieve the objectives set for general government finances under the EU framework.

Objectives are set to be achieved by the end of the parliamentary term, and it is difficult to assess them in real time. In practice, their achievement can only be assessed during the next Government term, when the statistics for the year concerned have been completed. According to the data in the spring of 2020, the objective set for the parliamentary term 2015–2019 was missed by a significant margin, although during the parliamentary term, it was expected to be more or less achieved.

Stabilizing measures are based on the projections of general government finances

When planning its economic and fiscal policy during the preparation of the Government Programme and also during the Government term, the Government should define the measures for achieving the objectives. The methods are scaled on the basis of the projections of general government revenue and expenditure. The projections illustrate the development of general government finances if no new political decisions are taken. This sets high requirements for their quality and reliability.

As a rule, the Ministry of Finance prepares its medium-term projections appropriately. The Ministry has included discretionary policy measures in its projection in compliance with the guidelines of the EU Commission. The differences between the budget outturns and the original projections have been rather large, but there are natural reasons for this.

The uncertainty of the projections of general government finances is well illustrated by how they have changed in recent years (see Figure 2). In the spring of 2018, the outlook for the next few years was positive, and a slight surplus was forecast for the end of the review period. In the spring of 2019, the projections weakened significantly, and in the autumn of 2019, they were already showing a deficit of 1.5 per cent instead of the surplus forecast in the spring of 2018. Such projections are therefore uncertain even in normal circumstances. The subsequent weakening of the forecast in the spring of 2020 was caused by the fact that the econimic crisis made the outlooks plummet.

Visualization: General government deficit relative to GDP

Based on the forecast in spring 2018, the nominal balance of general government finances was assessed to improve to a surplus of 0.3 per cent in 2021 and 2022. Based on the forecast in spring 2019, the nominal balance of general government finances was at first assessed to improve to 0.0 per cent in 2020 and then fall to a deficit of 0.6 per cent by 2023. Based on the forecast in autumn 2019, the nominal balance of general government finances was assessed to grow to 1.5 per cent in 2021.
Forecasts of general government nominal balance in 2018–2019, % of GDP Source: Ministry of Finance.

As projections may change, it is entirely possible that the measures tied to them may prove either inadequate or excessive. The impact of the measures on general government finances is also surrounded by many uncertainties. This is especially true when the Government does not strive to achieve impacts directly through legislative amendments related to taxation or expenditure. For example, an improvement in the employment rate may have very different impacts on the balance of general government finances, depending on whether it is caused by an increase in full-time or part-time employment. Although it may be difficult to assess the impacts of some measures, it is not justified to select primarily measures that are easier to assess.

It is necessary to set evaluation points within the parliamentary term for the impacts of Government decisions.

However, the Government can strive to ensure that the measures are implemented as planned. During the government term, it would therefore be important to have evaluation points to assess the impacts of the decisions taken on the balance of general government finances and to consider the need for additional measures. In this respect, the present Government Programme includes the right kinds of element, such as the examination of increases in expenditure based on the milestone set for the employment rate.

Sustainability assessments should not serve directly as a foundation for fiscal policy but can help to identify the need for structural reforms

Long-term sustainability assessments, such as the sustainability gap, involve even more uncertainties than medium-term projections. Although improvement of the sustainability of general government finances is an important fiscal policy objective, it is not justified to use sustainability assessments mechanically in the setting of fiscal policy objectives and in the steering of general government finances. This is because they emphasize many of the problems related to economic indicators.

First, sustainability assessments are highly uncertain. For example, the underlying assumptions of population projections have a significant effect on the assessments, and demographic factors (e.g. birth rate and immigration) can vary greatly. Changes in calculation methods and assumptions can also result in a substantial fluctuation in the value of the long-term sustainability gap. Not all the factors having significant effect on sustainability can be impacted directly by political decision making. In sustainability calculations, it is also difficult to take into account the potential detrimental effects that consolidation measures can have on long-term economic growth.

Long-term sustainability is built into the EU-level medium-term fiscal policy regulation (see Figure 1). Long-term spending needs thereby impact the strictness of medium-term objectives, which further reduces the need to set a separate objective for the sustainability gap during the government term, for example.

Comprehensive assessments of the sustainability of general government finances should be made and reported to Parliament.

In any case, sustainability assessments are quite useful for assessing the need for structural reforms in the long term and for building a comprehensive situational picture. There is clearly a need for more extensive sustainability analyses in Finland. Statutory sustainability reporting to Parliament should be strengthened, and it should be linked with a medium-term review. The National Audit Office therefore proposes that fiscal policy legislation be amended to oblige the Government to cover the sustainability of general government finances comprehensively in the General Government Fiscal Plan. In practice, this would mean calculating sustainability assessments for different periods based on several alternative scenarios.

The following visualization shows how the ratio of total age-related expenditure to GDP will develop in the EU countries, Norway and Great Britain according to different scenarios in a time span of about 50 years. Age-related expenditure refers to health care, long-term care, pension, education, and unemployment expenditure.

At the top left of the visualization, you can opt to view the data on several countries according to a certain scenario (“View by scenario”) or the data on a certain country according to several different scenarios (“View by country”). Select a scenario or country from the drop-down menu at the top right. You can add scenarios or countries by clicking on them at the bottom of the figure and remove them by clicking on them again.

 

Further information

Mika Sainio
Principal Fiscal Policy Auditor