Delroy Hunter | The cost of using fiscal councils to achieve discipline

Jamaica is in the process of establishing a fiscal council, an entity tasked with assisting the government in conducting more fiscally responsible operations.

If the government emulates the best in class, then the local fiscal council should be a legally and operationally independent entity that assesses government’s forecasts of revenues and expenses, develops its own forecasts, makes possibly binding recommendations on matters of fiscal policy, and robustly communicates with the public on the issues affecting national fiscal conditions.

If a fiscal council already existed in Jamaica, perhaps its presence would have influenced the recent budget debate by tempering the opposition’s call for the government to increase its expenditure to assist Jamaicans to cope with the effects of high inflation. It could have also bolstered the assertion of the Private Sector Organisation of Jamaica, PSOJ, that additional expenditure could place Jamaica’s economic stability at risk.

It is reasonable to assume that the government is incentivised to establish a fiscal council by the expectations that a successful council could, inter alia, enhance the accuracy of the government’s forecasts, reduce fiscal deficits, lower fiscal policy uncertainty, and ease the crowding out of the private sector from the credit market as the government’s need to borrow declines.

Judging from the persistent and substantial fiscal deficits that have plagued Jamaica, and the tendency for successive governments to be less than fiscally judicious, especially prior to national elections, it might appear like a foregone conclusion that establishing a fiscal council would be all-round beneficial. However, real life tends to be more complicated. While there is emerging empirical evidence that fiscal councils achieve some of their core objectives, there is the need for a cautionary note on their adoption.

Financial development

In research conducted for my recently concluded Fulbright Scholarship at the UWI Mona School of Business and Management, I investigated whether the adoption of fiscal councils affects financial development of the adopting country’s financial sector.

Financial development is assessed along three main dimensions of financial markets. Access reflects the ease with which residents can obtain the services generally offered by financial markets and is captured by, for instance, the number of bank branches or securities issuers relative to the population

Depth reflects the diversity and financial value of the securities within financial markets in relation to a measure of overall economic activity, such as gross domestic product. Efficiency captures the speed at which financial transactions are concluded, the costs to conduct these transactions, and the relative profitability of the transactions to the institutions offering the financial services.

Understanding whether, and how, government policies affect financial development is important, as there is now robust evidence that financial development drives economic growth. In addition, developed financial markets are a critical element of modern societies, in the sense that they assist us in participating in the wealth created from economic growth and more efficiently facilitate savings/investing, raising capital, making/receiving payments, and managing risks.

Overall, financial development increases social welfare and requires a nurturing environment.

Competing views

There are two broad competing views on how fiscal councils could affect financial development. The commonly held expectation is that fiscal councils improve financial development by increasing fiscal balances, lowering fiscal policy uncertainty, and reducing governments’ footprint in the credit market and thereby easing private-sector credit constraints.

In contrast, fiscal councils can retard financial development if their adoption significantly reduces government consumption expenditure, improves governments’ capacity to extract taxes from the economy, and increases consumption risk for individuals. That is, greater tax extraction from society and lower government consumption expenditure can influence the behaviour of both those who supply capital to, and demand capital in, the financial markets and, consequently, financial development.

The study finds that fiscal councils retard financial development. It is based on 40 years of data from 185 countries, about 45 of which established fiscal councils during the study period. This finding holds for the broad financial sector, as well as for its financial markets and financial institutions subsectors separately.

The result is similar for European adopters of fiscal councils, as well as for non-European adopters that include some developing countries and, consequently, should be of relevance to Jamaica.

The finding that fiscal councils retard financial development is somewhat surprising, and speaks to a concern of policymakers that policies could have negative, unintended consequences or, in the jargon of economists, ‘negative externalities’. In assessing this finding, we should be clear that there is evidence that fiscal councils achieve their primary objectives, such as reducing budget forecast errors, increasing fiscal balances, and broadening the discussion of fiscal policy.

The study finds that the negative effects of fiscal councils on financial development arise from a combination of factors, including the fact that they reduce total (government plus household) consumption expenditures and increase net tax intake. The research also finds that fiscal councils cause a decline in private-sector borrowing while not affecting the lending premium, the difference between loan rates and government Treasury bill rate.

Taken together, these findings suggest that fiscal councils reduce the cash flows of firms and do not improve their access to credit.

Implications for Jamaica

The overarching implication of the study’s findings for Jamaica could be summarised as ‘buyer beware’, because the fiscal council ‘medicine’ for the country’s fiscal maladies might have its own side effects.

While the International Monetary Fund’s financial development index for the United States has increased from about 0.4 to 0.9 — within a range of zero to one — over the last 40 years, Jamaica’s index has been around 0.25, even though since 2019 it has crept above 0.30.

Over the last decade or so, Jamaica has implemented a series of legislative changes designed to improve the financial sector. Legislators should exercise due care to avoid moving financial development one step forward and, unintentionally, two steps backwards while implementing new policies.

The above findings prompted additional analysis to determine whether certain design features of fiscal councils are associated with greater financial development. The findings suggest that fiscal councils should be given a broad mandate to influence the budgetary process and actively communicate with the public.

Since the mandates would require developing budget and other forecasts, the personnel choices have direct bearing on achieving the mandates, and said choices should be made with this in mind.

Given the negative consequences for financial markets and the fact that financial development is not an objective of fiscal councils, the governance of the local fiscal council should give voice to financial market advocates, and the government should not be reluctant to pull the other levers of financial development that are in its control.

Delroy M. Hunter, PhD, is the Serge Bonanni Professor of International Finance at the University of South Florida. dhunter2@usf.edu