The Chilean Fiscal Rule¹

Michael Pedersen², Central Bank of Chile

INTRODUCTION

In many countries and several situations, fiscal policy has contributed to creating imbalances, thereby increasing economic instability. A fiscal framework is desirable in order to support sustainable economic devel opment. This article describes Chile's fiscal rule, which has worked suc cessfully as part of the foundation for the favourable course of the Chilean economy in recent years.

In the past decades, Chile and other Latin American countries have been subject to a high degree of macroeconomic volatility, which has resulted in large fluctuations in economic growth and exchange rates and, in some cases, hyperinflation. One of the reasons for this volatility has been large movements in international commodity prices – raw materials are im portant export articles for the region – combined with pro-cyclical macro economic policies. To move towards a countercyclical framework, in order to smooth economic fluctuations, Chile in 2000 adopted a structural surplus rule as the basis for fiscal policy from 2001 onwards.

Under this rule, the Chilean government undertakes to maintain nominal expenditure equal to structural revenue minus the structural surplus target as a percentage of GDP. The indicator of the structural balance nets out the cyclical impact of economic activity, the long-run copper price and the structural income from the sale of molybdenum. This indicator reflects the revenue that the central government would receive if the economy grew at the trend output rate, i.e. with full employment, and with the prices of copper and molybdenum at their long-run levels.

Compliance with the rule is not a legal obligation but a voluntary undertaking on the part of the government.³ To ensure the credibility and transparency of the rule, independent experts have a substantial influence in setting a ceiling to public expenditure, which makes the Chilean fiscal rule unique in its application, compared with similar rules applied elsewhere. Since 2001, these panels of experts have defined the long-run reference copper price and, since 2002, also the parameters used to calculate potential output (trend GDP). On the other hand, the target for the structural surplus is decided by the government.

The present article briefly describes the functioning of the Chilean fiscal rule and the way it is applied. In the next section the rule is described, followed by an outline of the work of the independent panels of experts. The final section briefly describes the experience with the fiscal rule.

THE FISCAL RULE

The fiscal rule is formulated in terms of the structural balance. Unlike the current balance, the structural balance reflects the fiscal outlook in the medium term and it is defined as the difference between fiscal income net of the impact of the economic cycle and the expenditure that is compatible with this income.

In general terms, the fiscal rule states that

Structural revenue – public expenditure = X per cent of GDP,

where X is the target of the structural surplus. Until 2007 the target was 1 per cent of GDP, but it has been reduced to 0.5 per cent of GDP as from 2008. In other words, in 2008 public expenditure must, according to the rule, not exceed the difference between structural revenue and 0.5 per cent of GDP in the same year.

When the rule was introduced, a surplus of 1 per cent of GDP was considered sufficient to ensure accumulation of financial assets in order to finance future public commitments, in particular the guaran teed minimum pension and old-age benefit. Furthermore, a surplus target seemed appropriate since the Central Bank of Chile had a structural operating deficit as well as negative net worth due to losses related to the bailout of the private banking system in 1982 and accumulation of international reserves in the 1990s. In 2007, the target was revised and it was decided to reduce it to 0.5 per cent from 2008, cf. the Appendix.

The indicator of the Chilean structural balance is calculated by netting out the cyclical impact of economic activity and deviations from long-run prices of copper and molybdenum. Because of heavily rising molybdenum prices, cf. Chart 1, public revenue from molybdenum production by Codelco, Chile's largest mining company, was included in the fiscal rule in 2005. In Chile, copper is the main product for exportation and it accounts for more than 50 per cent of total exports, cf. Chart 2.

A large share of public revenue comes from the mining sector in the form of royalties, taxes and direct transfers from Codelco, which is pub licly owned, cf. Chart 3.

According to Rodríguez et al. (2007), the structural balance indicator for Chile can be expressed in terms of the effective balance (accrued) and four more terms: (1) the difference between structural and actual net non-mining tax revenue and social security in-payments; (2) the difference between structural and actual income from taxes on private mining companies; (3) the difference between structural and effective transfers from Codelco on account of copper sales; and (4) the difference between structural and effective transfers from Codelco on account of molybdenum sales.

While the latter is calculated assuming that the molybdenum long-run reference price is equal to a historical average, the calculation of the former three terms requires information of variables, which are unob servable by nature: trend GDP and the long-run copper price. Estima tions of these variables are made by independent expert panels.

THE INDEPENDENT EXPERT PANELS

With the purpose of improving the transparency of the conduct of fiscal policy, the Chilean government decided in 2001-02 to have panels of in dependent experts decide two of the important parameters of the fiscal rule described above: trend output and the long-run copper price.

The members of the trend output expert panel are selected on a per sonal basis and do not represent the institutions with which they are associated. For example, three of the 15 members who participated in the panel in 2007 were also members of the central bank's board. In the six years from 2002 to 2007, the panels have consisted of between 14 and 17 members. The meetings were held in June, July or August and the minutes of the meetings were published shortly after.

Prior to the meeting, the members receive a methodological note with background information and historical data. Based on this information the members are asked to provide estimates of the growth rates of each of the three variables necessary for the calculation of trend output for the following year: Total factor productivity (TFP), investment and the labour force. The members are required to make estimates for the following five years. For each year, the highest and lowest observations are eliminated and an average of the remaining is used in the calcula tion of trend output.

Trend output is the theoretical level of output, if the economic resources are used with "normal" intensity and productivity is at the normal trend. The aggregate production function is assumed to be a Cobb-Douglas type with constant returns to scale. Potential output growth rates for the following five years are calculated by inserting in this function the estimates provided by the panels, cf. Pedersen (2008). Estimated trend growth has been 4-5 per cent since 2002, cf. Chart 4.

In 2001 it was decided to invite independent experts to determine a ref erence price for copper. This panel has so far consisted of 8-12 members, and the meetings take place around the same time as the meetings of the trend output expert panel.

The panel is asked to provide an estimate of the average copper price in dollars for the following 10 years. The highest and lowest observa tions are eliminated and the average of the remaining is used in the cal culation of the structural balance. Chart 5 shows the averages reported for the period 2002-07 and the highest and lowest observations, i.e. those excluded before calculating the average. The higher the reference price, the higher has been the difference between the highest and the lowest estimates. In relative terms, the difference between highest and lowest has increased from an average of 10 per cent of the final ref erence price in 2002-04 to 24 per cent in 2005-07.

EXPERIENCE WITH THE RULE

Since the rule is not enforced by law, a natural question would be if the government has conducted fiscal policy in accordance with the rule. The answer is "yes". According to the government's official data, the struc tural balance has been exactly 1 per cent of GDP in 2004-07, while the actual fiscal balance has been substantially higher, cf. Chart 6.

Since there are only few observations available, it may be too early to evaluate the countercyclical nature of the rule. However, in 2002 and 2003 Chile experienced relatively low growth rates, and the government balance was negative in both years. As economic growth picked up in the following years, so did the government balance, cf. Table 1, sug gesting that the rule has indeed been countercyclical in the first six years of its existence.

Mainly because of the high copper price, the conduct of fiscal policy according to the rule has implied an increase in public savings from 2 per cent of GDP in 2002 to 12 per cent in 2007. At the same time, the government debt has been reduced substantially from more than 15 per cent of GDP in 2002 to 4 per cent in 2007. Relative to output, govern ment interest payments declined to half in the same period. Hence, since the introduction of the fiscal rule, public finances have improved signifi cantly, and in 2006 the government created two sovereign wealth funds, the Economic and Social Stabilisation Fund (ESSF) and the Pension Re serve Fund (PRF).

The purpose of the PRF is to fund government pension obligations and to help pay for the expected increase in the minimum pension benefit take-up rate. The government surplus of the previous year, with a minimum of 0.2 per cent of GDP and a maximum of 0.5 per cent, is de posited in this fund until it reaches 900 million UF.⁴ Estimations indicate that with annual contributions equal to 0.2 per cent of GDP it should take around 25 years to reach 900 million UF and that this amount should finance pension payments for 25 years. Every three years, the Chilean Ministry of Finance must evaluate the sustainability of the fund. After subtracting deposits in the PRF and capital contributions to the Central Bank of Chile, the remaining government surplus is deposited in the ESSF. The main purpose of this fund is to smooth out the financing of public expenditure, such that deposits are made in surplus years and funds are withdrawn in deficit years. Both funds are administered by the Central Bank.

As a measure of the credibility of fiscal policy, the yield spread between Chilean and US government bonds⁵ can give some indications. The spread narrowed from more than 200 basis points in early 2001 to levels under 100 basis points in the 1st half of 2007. However, the spread has widened again and in July 2008 the average spread was recorded to be 181 basis points. With this evidence, there are some indications that the credibility of Chile's fiscal policy has improved since the adoption of the rule, but given the turmoil in the financial markets over the past year it is difficult to extract any clear signal from interest rates.

In general, international organisations agree that the implementation of the fiscal rule in Chile has been a success. For example, the executive summary of the IMF's article IV report about the macroeconomic frame work states that "Successful implementation of this framework has created increasing room for addressing social priorities, which the authorities intend to pursue in an incentive-compatible manner, accom panied by further increase in transparency."⁶ Another example is the IADB's 2007 report on economic and social progress in Latin America, where it is recognised that "the Chilean fiscal rule has worked well. While structural balances mimicked the actual balance before the adop tion of the rule, since 2001 the average structural balance has been more or less constant."⁷

There is no doubt that the implementation of the structural surplus rule in Chile has benefited economic stability. It has been widely ac cepted as a credible and transparent commitment. From the beginning, the rule has been subject to continuous refinement and is at the core of fiscal credibility. This credibility is very important for a country that has been affected by a high degree of macroeconomic instability in the last decades.

LITERATURE

Chilean Ministry of Finance (2002a, 2003a), Acta. Resultados del Comité Consultivo del PIB Potencial.

Chilean Ministry of Finance (2004a, 2005a, 2006a, 2007a), Acta. Resultados del Comité Consultivo del PIB Tendencial.

Chilean Ministry of Finance (2002b, 2003b, 2004b, 2005b, 2006b, 2007b), Acta. Resultados del Comité Consultivo del Precio de Referencia del Cobre.

Chilean Ministry of Finance (2007c), Informe de Pasivos Contingentes 2007.

IDB (2007), Living with debt. How to limit the risk of sovereign finance, Economic and Social Progress in Latin America. Report.

IMF (2001), Government Finance Statistics Manual.

IMF (2007), Chile: 2007 article IV consultation – Staff report; public information notice on the executive board discussion; and statement by the executive director for Chile, IMF, Country Report, No. 333.

Pedersen, Michael (2008), The Chilean fiscal rule, Danmarks National bank, Working Paper No. 57.

Rodríguez, J., C. Tokman and A. Vega (2007), Structural balance policy in Chile, OECD, Journal of Budgeting, vol. 7(2), pp. 59-92.

Velasco, A., A. Arenas de Mesa, L.F. Céspedes and J.R. Cabello (2007), Compromisos fiscales y la meta de superávit estructural, Chilean Ministry of Finance, Estudios de Finanzas Públicas, May.

APPENDIX MAIN CHANGES IN THE FISCAL RULE⁸