Fiscal Rules and Government Efficiency in Reducing Procyclicality in Emerging and Developing Economies

A policy objective for many emerging markets is to reduce the procyclicality of fiscal policies and dampen business cycle fluctuations. Chile is a well-known success story in this regard, partly because of its adoption of strict policy rules (fiscal rules) regulating government expenditures, taxation and debt. We investigate whether adopting rules-constrained fiscal policy similar to Chile would help reduce the procyclicality of fiscal policy in other emerging markets. We also examine whether fiscal rules — in reducing fiscal procyclicality — are complements or substitutes to institutional reforms improving the quality of government. To this end, we employ a dynamic panel framework with 97 countries over the period 1985-2012. We construct a fiscal rule index and investigate whether rules help to dampen procyclical policies, and whether the potential effectiveness of fiscal rules is related to the quality of government institutions. We find that fiscal procyclicality is mainly a problem for developing economies, rather than advanced and emerging economies. Fiscal rules are mainly effective in reducing procyclicality if implemented in conjunction with high government efficiency. Although higher government efficiency reduces procyclicality, the effect is much stronger when combined with fiscal rules.