Does the Stability and Growth Pact induce a bias in the EC’s fiscal forecasts

Enforcement of European fiscal rules, to a large extent, hinges on the fiscal forecasts prepared by the European Commission (EC). The reliability of these forecasts has received little attention in the literature, despite the fact that i) the forecasts have potentially far-reaching consequences for national governments, especially in the euro area while ii) the EC depends on information supplied by national officials in preparing its forecasts. We hypothesise that the EC’s forecasts are biased upwards when national  governments expect European fiscal rules to bind. Reconstructing this expectation using real-time information, we show that for euro area countries the EC’s fiscal forecasts are indeed biased upwards when the budget deficit threatens to exceed the critical value of 3% of GDP. For non-euro area countries, which do not face the risk of fines, this bias cannot be established. Our results are robust to various ways of controlling for crisis-induced budgetary problems and the exclusion of various country groups. We offer suggestive evidence that the presence of independent fiscal councils at the national level helps to attenuate the bias induced by the 3% threshold.
 
Keywords:  Forecast errors, Stability and Growth Pact, fiscal policy, political economy.
JEL classification: C53, H3, H68, E62.

Working paper no. 451