A Look at the EU's Revised Fiscal Rules

(Thierry Monasse/Getty Images)

European Commission Vice President Valdis Dombrovskis (left) and the EU Economy Commissioner Paolo Gentiloni (right) talk with reporters in Brussels, Belgium, on April 26, 2023, after presenting proposals to reform the bloc's fiscal rules.

Revised EU fiscal rules will grant member states greater flexibility to reduce their debt levels through bespoke fiscal adjustment plans, but could also reduce fiscal space for public investment in key policy areas such as defense and the green transition. On Dec. 20, EU finance ministers reached a preliminary agreement to reform the bloc's fiscal rules, collectively known as the Stability and Growth Pact (SGP). The deal will now be followed by inter-institutional negotiations between member states and the European Parliament and require formal approval from both, which is expected before EU elections in June 2024. EU capitals reached a compromise building on a reform originally proposed by the European Commission to give highly indebted countries more time and flexibility in setting tailored debt reduction plans, but the final deal adds a more stringent enforcement regime to ensure common debt reduction. Under the deal, member states with a deficit-to-GDP ratio that exceeds 3% and a debt-to-GDP ratio that exceeds 60% will be able to set their own fiscal adjustment paths (which would need approval by the European Commission), as long as they ensure their public debt falls over four years (seven, if they implement reforms that increase fiscal sustainability and encourage growth or invest in areas of common interest, like decarbonization or defense). However, they will also have to implement annual deficit and debt reduction targets. Countries that fail to comply with such targets would fall into a so-called excessive deficit procedure, which would require them to reduce annual spending by 0.5% of GDP or risk incurring financial penalties.

Countries with debt ratios above 90% of GDP will be required to reduce their debt by 1% every year over the duration of their national spending plan, while countries with debt ratios between 60% and 90% of GDP will have to do so by 0.5% every year. Additional budget targets are placed on countries with deficits above 3% and debt above 60% of their GDP, which will also be required to keep their deficits at 1.5% of GDP.
Countries subject to an excessive deficit procedure will be able to discount debt interest costs and investments under their post-pandemic recovery plans from their deficit calculations until 2027.

The reform is meant to re-establish fiscal discipline across the bloc, but with a more flexible approach, after back-to-back crises forced EU countries to dramatically increase their spending in recent years. The European Union's fiscal rules under the SPG are due to come back into force in 2024 after a four-year suspension. The rules were first suspended in 2020 to allow member states to increase public spending to cope with the COVID-19 pandemic; the suspension was then extended in 2022 to help countries endure the economic fallout from Russia's invasion of Ukraine. The European Commission had promised to reform the current framework, which is no longer considered fit for purpose in light of both the new high-debt reality that has emerged in Europe following the COVID-19 pandemic and the recent Ukraine-related energy crisis, as well as the future challenges the bloc faces — such as those related to climate change and the evolving geopolitical landscape — that will require higher levels of public investment from member states. This opened a debate between the bloc's more fiscally conservative countries and those with a tendency to keep higher fiscal deficits, with the former camp (led by Germany) pushing for a return of rigorous safeguards ensuring debt reduction, and the latter (led by France and Italy) seeking a more flexible framework to allow greater spending on key common EU goals such as rearmament and the green transition.

The new rules would replace the existing requirement for governments to cut debt by 1/20th of the excess above 60% of GDP every year. Debt-laden countries like France, Italy, Spain, Greece and Portugal have long viewed this requirement as far too demanding.
Fiscally conservative countries such as Germany and the Netherlands, however, have called for stricter debt-reduction targets and have deemed the shift from universal rules to bespoke debt-reduction paths under national plans as too loose, fearing highly indebted countries would enjoy too much discretion in how to consolidate their public finances.

Despite the increased flexibility, the reintroduction of numerical benchmarks for fiscal and debt reduction against the backdrop of higher debt levels and higher borrowing costs will constrain highly indebted countries' ability to spend. While moving away from the current one-size-fits-all approach to debt and deficit rules, the new fiscal framework retains baseline requirements for countries with high levels of public debt to implement annual deficit and debt reduction targets in an effort to ensure increased financial stability across the bloc, as demanded by fiscally conservative member states. The revised rules, however, also allow highly indebted countries to set their own targets toward a gradual fiscal consolidation that takes into account economic reforms, macroeconomic conditions and investment needs. Yet, despite this increased flexibility, the fiscal adjustment that countries will need to undertake to put their debt on a declining path still comes at a time when several EU member states are facing higher debt levels and borrowing costs compared with when the rules were first suspended in 2020. In this environment, public investment in areas such as energy security, decarbonization, defense, digitalization, supply chains and green and tech industrial production will be harder to pursue for countries that will fall under the excessive deficit procedure.

According to the European Commission's autumn economic forecasts, deficit levels in 12 countries (including France, Italy, Spain, Poland, Belgium and Romania) will exceed the 3% of GDP target in 2023, likely falling under the new corrective mechanism in 2024. However, due to the upcoming EU elections in June, Brussels is unlikely to take any corrective action against these countries until the second half of next year.

The reduced fiscal space for public investment in key policy areas may reignite north-south divides in the European Union over time, and increase calls for greater fiscal integration or increased common financing. Spending on defense (which entirely relies on public investment) and the energy transition (which largely depends on government initiatives to mobilize private capital) could face funding shortfalls as current EU funds like the NextGenerationEU offer only limited relief. Against this backdrop, some EU states, particularly in the south and east, may find themselves at a crossroads: adhere to fiscal constraints or prioritize key policy goals, which would likely reignite north-south divides within the bloc. Moving forward, Brussels, as well as the European Union's more fiscally conservative member states, may therefore face growing pressure from countries like Italy, Spain and France to either move toward deeper EU fiscal integration or, at the very least, increase common financing mechanisms to fund key projects of common interest, such as energy interconnections, industrial subsidies and joint defense procurements.

NextGenerationEU funds will expire in 2026, meaning southern and eastern EU member states that are currently receiving large amounts of the funds will have even fewer resources available for the second half of the decade to maintain public investment in areas like the green and digital transitions.