Rule-Based Budgeting: The Road to Budget Stability¹.
The Hungarian Solution

Civic Review, Vol. 13, Special Issue, 2017, 39–63, DOI: 10.24307/psz.2017.0304

Summary

Starting from the macro-economic processes of public finance, this article examines the road to reaching financial stability and sustainable economic growth. It outlines the role played by rule-based budgeting in this process. It introduces the regulatory and institutional solutions and explains how, as a logical consequence of being part of a framework, this service can become a useful aspect of financial policy by implementing the respective regulations of the system and of annual budgetary practice. It reaches the conclusion that “elevating” the major stipulations of the rule-based budget framework and the operational rules of the institution safeguarding the implementation into the Fundamental Law of Hungary in 2001 was unavoidable from the aspect of strengthening fiscal responsibility. The article deals with the linkages of the Stability Act, the major characteristics of the work done by the Fiscal Council and the body’s recommendations made in the last few years. Finally, it illustrates with some data the improvement of fiscal (public finance) stability supported by rule-based budgeting.

Journal of Economic Literature (JEL) code: B15, E62, H15, H61, H63, L38, P48
Keywords: fiscal policy, crisis management, debt management, fiscal stability

Introduction – The essence of rule-based budgeting

It is common knowledge that in the course of implementation of the goals of fiscal policy in order to reach a lasting position of near budgetary (public finance) balance position and the financial viability of social services, it is of decisive importance to maintain the measure of state redistribution at the level required to reaching these goals. The maintenance of state redistribution at the required level is also a primary condition for the regional and global competitiveness of the entire national economy, both from the aspect of the long-term decrease of government debt and also, ultimately, in terms of the sustainability of socioeconomic development.

Lack of financial stability paralyses, or can paralyse, the social-economic functioning of a country within a few years. That is why regaining and maintaining this stability has become a strategic issue across the globe and has required new solutions, rules and institutions. The so-called rule-based fiscal policy framework that was first applied in the economic crisis-ridden states of Latin America and then, from the 1980s onward worldwide, and thus also in Europe, fits this target system (Kutasi, 2012).

The so-called “rule-based fiscal policy” means more than the regulatory compliance² of the preparation and implementation of budgeting, as this dictates the fiscal responsibility framework via the rules of budgetary policy, procedural-transparency regulations and – additionally – via the institutional mechanisms that represent the guarantee of observing these rules (Kutasi, 2012). The system used in practice is made up from these regulations and mechanisms – in harmony with the specific features of the given country (Ódor, 2014).

From the middle of the 2000s it became obvious in Hungary too that in order to prevent expenditure overruns that diverged from economic performance it was not enough simply to be more disciplined when it came to the implementation of the current budget. Regaining and maintaining financial stability became a strategic issue that required new constitutional stipulations that uniformly regulate public money matters and high level legal norms that rely on these new stipulations. The Hungarian efforts to put the finances of the country on a solid basis from the second half of the past decade, together with the cessation of expenditure overruns, successfully served this purpose when, five years ago, these goals were incorporated in the Fundamental Law of Hungary³ and institutionalised in the Stability Act⁴.

This article focuses on introducing these regulations and is then followed by a detailed analysis of the road to regaining fiscal stability.

Sketchy international outlook

Reasons for introduction and principles of rule-based budgetary practice as a therapy

Expenditure overruns have occurred in a long line of emerging and developed countries in the past few decades and, as a consequence, the problem of sustainability and growing debt has been accompanied by bank crises⁵ (Antal, 2004; Bod, 2013; Győrffy, 2009; Muraközy, 2010).

Governments of several countries chose to introduce rule-based budgeting in the hope that it could help to confine balance-related tensions and create lasting financeability, growth and sustainable development. To this end, they incorporated into constitutional stipulations the proportions of the expenditure and revenue sides of the budget as well as the acceptable degree of indebtedness – in the form of numerical regulations, planned alongside a set rule of procedures and institutionally controlling the budget (Kopits, 2007; 2013).

In practice this meant that they:

International experiences of applying this system have shown that its consistent operation could reverse the trend that throughout the last decades has been manifested in a long line of emerging and developed countries in the form of budgetary over-spending, the unsustainability of the budget and the growing government debt (Oblath–Szapáry, 2006).

Solutions in international practice

Some countries had already introduced rule-based budgeting before the 2008 crisis and they established independent fiscal institutions (see Table 1).⁶

It is apparent that they were using elements of the rule-based method in very different ways (Jankovics, 2012). Most frequently, however, the general balance requirements emerge and we can also find more concrete stipulations, such as setting a limit (ceiling) concerning indebtedness and calling for medium-range planning (Kopits, 2013). The method of calling for an independent institution can be different as well: in most cases it occurred with a simple law or political guideline (agreement), but in the case of Poland, for example, it was through the constitution. The countries of the euro area fixed the requirements in an agreement.⁷

A diverse picture has also enfolded in the EU Member States in the period following the 2008 crisis. From the “picture taken” on 1 January 2016, we have separately examined the individual countries belonging to the groups that accessed the EU before 2004 (see Table 2a and 2b) and those that accessed the EU from 2004 onwards (see Table 3a and 3b) (Adema, 2008). As a consequence of the crisis, the number of countries that have introduced the stipulations of rule-based budgeting has also increased among the countries that had accessed the EU earlier.⁸

We have to note that in October 2015 the European Commission established the Independent Fiscal Institution of the Union, the European Fiscal Board⁹, as an opinion-giving body that plays an advisory role. Its activities, mandates and examinations were limited to the countries of the euro area. According to the resolution, the new body will work independently from the national and European institutions, but in cooperation with them.¹⁰

Twelve of the 13 countries that accessed the EU in 2004 or later, operate rule-based fiscal regulatory mechanisms, together with the independent institutional guarantees ensuring the observance of these rules. The system was already set up prior to the outbreak of the 2008 crisis in four countries while in another five – among them in Hungary – it was introduced in the period 2009–2012.¹¹

The picture is mixed with respect to the utilisation of the elements of rule-based budgeting as well as the functions and responsibilities of the individual fiscal institutions.¹² One “novelty”, however, stands out and this concerns us. This is the application of the veto right (we will deal with this in more detail later).

Let us end the rather sketchy international outlook with the question of whether financial management has become more disciplined in the budget sector with the entry of the fiscal rules and institutions (fiscal councils). It is a fact that in the majority of the countries, following the introduction of a stricter system, the rate of government debt began to decrease (see Figure 1), and economic growth also started, more powerfully in the group of the Visegrád countries. Although the financial system of some Southern European states can, from time to time, be operated with the help of their own “forced solidarity”, the practise of rule-based budgeting has brought certain results here too.

Accordingly, we can clearly reach the conclusion that the strengthening effect on discipline of favourable, problem-solving financial management can be demonstrated. This can be directly experienced mainly in the gradual relief of the burden of indebtedness. We should note, however, that the degree of the contribution of rulebased budgeting to the strengthening of fiscal stability strongly depends on the ability of society and the political leadership to recognise the capacity, socio-economic will and, naturally, the authorisations in constitutional law of the institutions safeguarding the observance of this set of rules.¹³

Domestic fiscal policy in the past decade and a half

Problems in managing public finance and the human factor

First of all, let us see why and how we reached the recognition in the middle of the 2000s that, in order to establish stability in fiscal (budgetary) policy in Hungary it was unavoidable to introduce stricter regulations and the consequent control of their functioning.

After the turn of the millennium it was not only Hungary that was facing more and more unmanageable public finances, overspending and, as a consequence, deepening problems of indebtedness that led to the undermining of the financial stability of the country. However, the situation was different for us in that the overlap of the political and economic cycles and the processes through which they strengthened or weakened each other – the effort to maximise votes – have resulted in expenditure overruns and the ensuing indebtedness, and most likely they played a larger role than in other countries with similar fates¹⁴ (Karsai, 2007). Therefore, before we deal with the introduction of rule-based budgeting to Hungary, it is worth briefly looking beyond our borders.

It is obvious that in the system of relations of financial policy outlined in the introduction, reaching the desired goals depends not only on establishing the appropriate rules, but also on their disciplined observation and enforcement. But in this process the human factor and the ability of society to recognise its interests and its will to follow these rules play important roles without which the financial stability of a country can scarcely be realised (Kovács, 2016a).

Following the transition to democracy in Hungary, the fiscal policies followed by subsequent governments were characterised by bargaining mechanisms, with a planning and financial management procedure that was built on political promises and dogmas. This presented an obstacle for public finance stability and sustainable development (Antal, 2004; Csaba, 2007; Karsai, 2007; Lentner, 2008; Matolcsy, 2008; Muraközy, 2010 and others).

Consequences measurable by financial indicators

From time to time (mostly in years close to the elections) the public finance deficit has “skyrocketed”; in 2002 and in 2006 it was close to 10 per cent of the gross domestic product (GDP) (see Figure 2).

The continuous increase of the measure of government debt expressed as a proportion of GDP (government debt rate) up to the introduction of the rule-based fiscal policy in 2010 was a direct consequence of the high deficit level (see Figure 3).

In the first half of the 1990s and then, following a temporary decrease, in the 2000s, the country was heavily burdened not only with the paying back of the soaring government debt but also the very expensive financing of the debt (debt service, i.e. the interest rate). “In the period of 1993–1999 in Hungary the expenditure on interest exceeded the expenditure on education, culture and health care” (György–Veres, 2016). To this we can add that, even in the years following 2010, servicing the debt tied up the same amount – i.e. 8-9 per cent – as that used for financing health care and was scarcely less than the 10–11 percent dedicated to education.

The peaking – especially when compared to the neighbouring countries and also to the OECD average – of state redistribution at close to 50 per cent of GDP, was the direct consequence of our fiscal policy (Figure 4).

It was inevitable that the huge amount of withdrawn income (and more specifically, the high degree of tax centralisation) that was necessary for state redistribution, encouraged tax evasion that, as a consequence, led to a reduction in the number of taxpayers, the erosion of the tax base and even to higher tax rates. As a result, private sector investments have shrunk. Companies being forced out of the credit market also contributed to this trend.

The aforementioned reasons appearing in Hungary together with a number of other factors, like ever-decreasing productivity, led to a more moderate growth, and occasionally even to recession, compared to the neighbouring countries, and the level of growth could only be maintained by the continued involvement of external sources i.e. indebtedness (see Figure 5).

Courage was missing from the public finance reforms – consolidation attempts – announced by the governments of the period in the aftermath of the transition to democracy. Lack of social acceptance and support played a role in their failures or – at best – half-successes, as well as the lack of adjustment to the economic viability (taxpaying ability) of the country when it came to a powerful structural transformation and the tasks undertaken by the state. Furthermore, they did not set requirements to promote the more efficient utilisation of public funds.

The above-mentioned oversized public finance and the subsequent “greed” and inefficient system of operation exerted a negative effect on the national economy and this also contributed to the declining competitiveness of the country.¹⁵

Despite the excessive weight of public finance people experienced a continuous worsening of the level of public services and thus their quality of life, i.e. their expectations have not been met despite the promises given in the election campaigns (Kovács, 2016a). In addition, the economic crisis of 2008 that started in the money markets and expanded to a general crisis further weakened our position thanks to the already weak situation of the Hungarian economy.

Introducing rule-based budgeting in Hungary
– Antecedents and institutional solutions

By 2006, following the deepening problems of Hungarian public finance that were endangering its sustainable financing and damaging the competitiveness of the real economy, it had become obvious that the budgetary practice followed ever since the transition to democracy had excluded the possibility of stepping on of the path towards sustainable development. The change could not be deferred any longer; a genuine change was needed in fiscal policy. However, the question was what should be the contents of such a change.

Balancing on the edge of fiscal unsustainability led to the recognition that in order to maintain the long-term sustainability of public finance, the direction of government had to insure, already in the short term, a regulation that was consistent and appropriate for the selected scenario as well as fiscal planning in the financial system that was “thinking” in the longer term, and independent control overseeing the observance of the regulations.

Dual search for a solution (2006–2007)

Experts were seeking solutions in two directions regarding the character of the regulations required for fiscal sustainability, as well as the institutional guarantees of their observance.

The theses on modernising public finances elaborated by the State Audit Office of Hungary assumed that in order to have significant change, the whole management of public funds would have to be regulated and made transparent and accountable. However, the agreement concerning the necessity and usefulness of comprehensive redefinition proved to be insufficient, owing to political divisions and the circumstances of a coalition government burdened with internal debates.

The other professional initiative focused on the most significant cause – the prevention of expenditure overruns – and regarded the adoption of the elements of rulebased budgeting, which were already successful in international practice, as appropriate for solving domestic problems too.

Accordingly, the development of the framework for rule-based budgeting was launched on the initiative of the State Audit Office of Hungary and the Central Bank of Hungary.

By the end of year 2008, and in the shadow of the threat of state bankruptcy and the pressure of borrowing from the IMF–EU, the Act on Cost-Efficient State Management and Fiscal Responsibility was born. Owing to its conception as an intervention mechanism that set limits on expenditure, this act was also referred to as the “Ceiling Act”. The act limited the grand total of budget expenditure for the following year (the plan for the year 2009 had to be equal to the provision for 2008, but later it could be increased by half of the expected rise in the real value of GDP). Besides this, they established complicated rules concerning the plannable balance of the budget and the envisaged extent of government debt.¹⁶

There were also two different plans for the Fiscal Council and its organisation. Although there was agreement on the idea that the chairman of the body should be an authority representing the head of state, there were different ideas concerning who should be the members of the body. One plan held that the members should be the incumbent presidents of the two financial institutions, i.e. the State Audit Office of Hungary and the Central Bank of Hungary, both institutions being independent from the government. According to this plan a secretariat with a small staff would take care of the general and organisational tasks, as professional support for the decisions made by the Council would be ensured by the SAO, which would check the foundations of fiscal planning at both the macro- and micro-economic levels as it could rely on its independent research staff, and the Central Bank with its existing, and traditionally high-level, capacity for macro-economic analysis.¹⁷

The other solution was significantly different from the above plan. In this second concept, apart from the authority representing the head of state, members of the body would be selected from experts nominated by the heads of the SAO and the Central Bank of Hungary. The secretariat would consist of a large number of staff, be financed by an independent budget and have significant expertise in macro-economic analysis.

In the end, the second plan was included in the “Ceiling Act” and this prevailed until the end of 2010 (Török, 2011). Then, from 2011, there was a return to the first plan, with the conditions of the transition being regulated by the 2011 Budget Act.¹⁸

Following the 2010 general elections, the new Government – enjoying a two-third majority in the Parliament – undertook the tasks of reviewing the whole of the legal system, and within this public finance, and setting up a new legal framework. This solution opened a new chapter, appropriate to the importance of the issue, with regards to the regulation of the rule-based budgeting system.

The Fundamental Law of Hungary and the Stability Act on rule-based budgeting

The Fundamental Law of Hungary, which was passed on 18th April 2011, dedicated a separate chapter to public finance. This chapter lays down the budget-making role of the National Assembly. Additionally, it states that the management of public finance shall be done in a transparent and accountable way, by keeping in mind the requirements of legality, expediency and efficiency. It also sets up a barrier for indebtedness, not only with regard to overall public finance but also, separately within it, to local authorities.

The Fundamental Law also defined the annually plannable extent of government debt when it created the government debt rule.¹⁹ According to this rule the National Assembly cannot pass a central budget act which would result in government debt exceeding half of GDP. As long as government debt exceeds half of GDP, the National Assembly can pass only a central budget act that contains the requirement to decrease government debt to GDP.

The Stability Act established a government debt rule not only regarding the planning and passing of the budget but also concerning its implementation. It states that as long as government debt rule exceeds half of GDP – with specific exceptions – no borrowing can take place in the course of the central budget implementation and no such financial obligations can be made as a result of which the proportion of government debt to total gross domestic product would increase compared to the previous year.

The Fundamental Law of Hungary elevated the Fiscal Council (in short: the Council or FC), which oversees the observance of fiscal stability, to become one of the conditions of the functioning of the Constitution. The Council is a body supporting the legislative work of the National Assembly and carries out its duties and tasks subordinated to the Fundamental Law and other laws. Among these tasks the FC participates in the preparation of the central budget bill; as an organisation supporting the legislative work of the National Assembly, on the one hand it examines – gives an opinion on – the foundations of the central budget, while on the other hand it gives its preliminary consent to the passing of the central budget bill in the interest of the observance of the government debt rule. The Council was granted a role as an independent fiscal institution with the above-mentioned duties and sphere of authority – i.e. the so-called right to veto – together with the accompanying responsibility.

This solution exceeds the practice of the majority of EU countries where – as we explained above – the work has mainly an awareness–raising and advisory character, not involving direct responsibility and tends towards a macro-economic analysis and technical forecasting with various reporting rights (that, in a limited way, might be strengthened by the relationship of the given institution to the SAO or the Parliament) (Domokos, 2012; 2015).

The framework for the Council’s duties defined by the Fundamental Law was further detailed by the Stability Act (see Figure 6).

It is the Stability Act that sets forth in detail the rules of procedure for the implementation of the mandatory duties of the Fiscal Council, including the duties of the Government, first and foremost by focusing on the process for enacting the budget bill. Thus, if in the course of formulating its opinion on the budget bill the FC expresses its lack of consent, then the Government shall have to confer again and reach agreement with the Council. The procedural rule concerning the provisional consent of the Council with regard to the bill’s accordance with the government debt rule is even tougher: if the Council resorts to using its veto right and rejects giving its provisional consent then the final voting shall have to be postponed and the procedure be continued until the Council gives its consent.

In addition to the above, the main duties of the Council are to express an opinion every six months on the implementation of the central budget act and the expected trend of government debt.

The FC monitors the macro economy and the implementation of the budget in the context of longer term macro-economic processes. For this purpose – just as when expressing an opinion on the budget – the Council relies on the analysis capabilities of the SAO and the MNB, and also on the work of research institutes, external experts, professional forums and advisory bodies.

With regard to the other, non-mandatory duties of the Fiscal Council, the Stability Act states that it can give its opinion on any issues that are related to the planning and implementation of the budget, the utilisation of public funds, and the state of public finances. From a broader perspective, satisfying social and professional/media interests fits within these duties, as well as asking for the opinion of economists, and responding to information requests from international organisations, cooperating with the independent fiscal institutions of other countries, and, likewise, the promotion of the stability of public finances using the tools of publicity (the Council’s resolutions, annual work plan, other documents, and research used for the FC’s work are available on its website).

Activities of the Fiscal Council and the balancing of public finances

The activities of the FC and the tools at its disposal – not least the body’s strong authority for promoting fiscal discipline, but also the guarantee of its presence –, have contributed to the balance-oriented budgetary policy, as a result of which the excessive deficit procedure (EDP) against Hungary was terminated in 2013, and the benchmarking parameters of public finance management have been realised, on the basis of which it became possible, in 2016, for international credit rating organisations to return Hungary to investment-grade status.

Some decisive resolutions of the Fiscal Council can be linked to this process:

The stability of Hungarian finances as the basis of growth

Growth determining the stability of the country and public finances has been present since 2013. It should be stressed that “the years of 2014 and 2015 were the first two years, ever since the early 1990s, when the Hungarian economy was able to grow without being followed by the growth of government debt and the external debt of the economy” (György–Veres, 2016:380). It is auspicious that economic activity has strengthened and that economic growth in the region exceeds the average of the euro area (see Figure 7).

The improvement of the government debt balance at the same time stimulates growth both in Hungary and in the neighbouring countries. It is the success of our rule-based budgetary policy that it is manifested not only in the decreasing trend in the public finance deficit but also in the fact that ever since 2012 our primary balance has been continuously positive, in contrast to the previous years when we were able to produce such a favourable result only for a year (Figure 8).

As a result of the marked improvement in the effectiveness of revenue collection, the adequate control of expenditures and the subsequent improving of the deficit indicators, after 2010 the government debt rate has been improved every year (as show in Figure 3). With the improving balance, the costs of financing the budget decrease. Cheaper financing then liberates resources for the economy and for society and thus represents a factor for growth. From the aspect of the “vulnerability” of the country, the spectacular fall of the ration of foreign currency within government debt is especially favourable (see Figure 9).

Instead of a summary

The characteristic of the “Hungarian model” that was renewed in 2011 is that, in order to prevent the earlier fiscal indiscipline, the FC was granted constitutional authority (right to veto) on the acceptance of the budgets (and their respective amendments). Apart from this it is also a characteristic feature of the Council that thanks to is budget-related constitutional authority, the body primarily deals with the stability risks of the current and the following year, utilises medium-term outlook and forecast data t, and does not bring them to the level of a corporate decision.

Generally speaking, the Hungarian system can successfully function not only because of its strict regulations, simple and transparent principles for fighting government debt and overseeing the observance of these regulations, but also because of its solutions, its effect on mitigating expenditure overruns, its awareness raising and confidence-building strength and its durability. In this way, it can contribute to the stabilisation of the country, to its sustainable development, the improvement of the country’s economic competitiveness and, ultimately, the advancement of the nation and the citizens of the country (Kovács, 2016b).

By the application of the elements of rule-based budgeting and the operation of the Fiscal Council, and also owing to the confirmation of the related requirements in the Fundamental Law and the Stability Act that made the regulations more transparent and consistent, the balance of public finances in the years following 2011 has clearly improved with respect to the deficit and debt indicators. Fiscal stability makes it possible for public finances to increasingly contribute to economic development. Competitiveness indicators²⁰ even today lag behind those of the Visegrád group of countries. Among a series of weaknesses, however, those related to the low effectiveness, excessive consumption and lack of financial stability of Hungarian public finances are no longer present today. These serious and determinant factors were responsible for the withdrawal of resources necessary for the economy and the dramatic fall of competitiveness in the 2004–2010 period.

The improvement of our balance situation affects our national competitiveness in a positive way. Further continuing the idea of linking competitiveness to the material and intellectual progress of our citizens, one must agree with a definition from Magdolna Csath that: “the economy is competitive when the abilities of the nation are useful and in the longer run keep gaining strength continuously, and when companies produce high added value, and as a consequence of these factors the standard of living and quality of life of the individuals keep improving” (Csath, 2016:5–6.).

Concerns the answer to the question “how to proceed” let me invoke once again the thoughts of László György and József Veress: “After having fended off direct dangers we can start developing those efficiency-improving and innovative factors that are able to set a solid foundation for competitiveness and economic growth […] first of all developing the following fields: vocational training, adult education, higher education, innovation, optimisation of the coordinating mechanisms of the economy and decreasing of the bureaucratic and administrative burdens of market operators” (György–Veress, 2016: 380).

Disciplined fiscal policy and making the work of public finance supply system more effective and efficient must contribute continuously to the future success of our national economy. There are plenty of tasks still to do for the Fiscal Council by contributing to the strengthening of fiscal responsibility.