Fiscal rules for natural disaster‐ and climate change‐prone small states

Abstract

How should small states formulate a countercyclical fiscal policy to achieve economic stability and fiscal sustainability when they are prone to natural disasters, climate change, commodity price changes, and uncertain donor grants? We study how natural disasters and climate change affect long‐term debt dynamics, and we propose cutting‐edge fiscal policy rules. We find the primacy of a recurrent expenditure rule based on non‐resource and non‐grant revenue, interdependently determined by government debt and budget balance targets with expected disaster shocks. This innovative fiscal rule is classified as a natural disaster‐resilient fiscal rule, which comprises a plethora of new advantages compared to existing fiscal rules. This new type of fiscal rule can be called as the third‐generation fiscal rule. It encompasses natural disasters and climate change, uses budget data only, avoids the need for escape clauses, and operates on a timely basis. Our rulebased fiscal policy framework is practically applicable for many developing countries facing an increasing frequency and impact of devastating natural hazards, and climatic change.