Why does the EU fiscal framework require more extensive fiscal adjustments from Finland than from other countries?

In the new EU fiscal framework, the change in the debt-to-GDP ratio is more important than the ratio as such. As Finland's debt is projected to grow in the coming years, the need for adjustments is high.

The purpose of the new EU fiscal rules is to put the general government debt ratio (debt-to-GDP ratio) on a downward path. The aim is to bring debt to a more moderate level in relation to the size of the economy. It would be easier to manage a lower amount of debt with the available revenue, such as taxes. A lower amount of debt would also provide valuable space for sufficient economic stimulation in the event of severe crises.

The reformed rules aim to achieve debt reduction by calculating such a difference between revenue and expenditure that would bring the government debt ratio down. In practice, this means calculating a net expenditure path based on general government revenue and expenditure. The net expenditure path can be derived from the results of the Debt Sustainability Analysis (DSA). According to the new rules, the net expenditure path must fulfil certain conditions in order for the debt ratio to follow a downward path and remain at a sustainable level.

Putting debt ratios on a downward path

One of the conditions, the so-called debt sustainability safeguard (European Union, 2024, Article 7.1), will restrict the development of the debt-to-GDP ratio already in the next few years. According to the rules, the debt ratio shall decrease by an average of 0.5 percentage points a year during the adjustment period (4–7 years) if the debt-to-GDP ratio is between 60% and 90%. If the debt-to-GDP ratio exceeds 90%, it shall decrease by an average of 1 percentage point a year during the adjustment period.

The idea is to bring debt ratios rapidly down if they have become too high. The debt sustainability safeguard is not the only condition used in the analysis, but as it produces the highest adjustment requirement, it is binding.

Finland vs. Austria

The adjustment need required by the new fiscal rules has also been calculated for Finland. Darvas et al. has replicated the calculation method that is used by the European Commission and described in the Commission’s publication. According to Darvas’s calculations, the debt sustainability safeguard is a binding condition for Finland because:
• Finland’s debt ratio is high, i.e. more than 60%,
• it is projected to grow very rapidly, and
• Finland is not in the excessive deficit procedure (EDP).

According to calculations, the debt sustainability safeguard is binding not only on Finland but also on Austria. Austria’s debt-to-GDP ratio exceeds 60%. Like Finland, Austria is not in the EDP process, and the debt sustainability safeguard is binding on Austria as well in the analysis. However, when these two countries are compared over the four-year adjustment period (2025–2028), the adjustment required from Austria is considerably less extensive than that required from Finland. What is the reason for this?

The reason is that the debt ratio is projected to grow significantly faster in Finland than in Austria. In the new EU fiscal framework, the change in the debt-to-GDP ratio is thus much more important than the ratio as such. In the no-policy-change scenario, Finland’s debt ratio is projected to grow by 12.7 percentage points between 2025 and 2028. However, the debt sustainability safeguard requires Finland’s debt ratio to decrease by 2 percentage points by the end of the adjustment period (see Figure 1). The difference between the target and the no-policy-change scenario is 14.7 percentage points. In Austria, the corresponding difference is only 4.7 percentage points.

Figure 1: Projected debt ratios in Finland and Austria. Source: Darvas et al. and calculations by Strifler and Kangasrääsiö.

Adjustments are needed

The results can be interpreted such that putting Finland’s debt-to-GDP ratio on a downward path does not happen automatically but requires a lot of work. We need either rapid economic growth or major fiscal adjustments. As economic growth in Finland is projected to be slow in the future – as has been the case since the financial crisis – the remaining alternative is to make major fiscal adjustments.

According to the European Commission’s first calculations, Finland would need adjustments of about 1.6 percentage points per year, which corresponds to an annual adjustment of more than EUR 4 billion. However, the final adjustment needs required by the rules are determined on the basis of the Commission’s assessment. The stock-flow adjustment included in the debt sustainability calculations has also been presented as one of the reasons for the need for major adjustments.

Read the second part of the blog, which deals with the stock-flow adjustment: “Debt calculations under the new EU fiscal rules take the Finnish earnings-related pension scheme into account more realistically than before”.

 

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