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Since the Maastricht Treaty, increasingly complex fiscal rules have been progressively introduced aimed at closely regulating and deeply affecting the budgetary policies of all signatory countries. One of the main reforms, enacted since 2005, has been to interpret national budget balances in structural terms, forcing each member state to comply with a Medium-Term Objective (MTO) based on the general principle of a zero-structural budget balance. Starting from the standard European Commission methodology for calculating the structural budget, our paper shows that, by replacing the estimate of the potential output based on the NAWRU with a different notion and measure of potential output, the results in terms of fiscal policy space are significantly different. This outcome points out the distinct possibility that the actual fiscal policies of the member states of the EU may be driven and constrained by a measure that seriously limits their flexibility by several percentage points. While our empirical calculations refer to Italy, the point we address is general and relates to all member states, particularly those that in the past have been forced to restrictive policies while in recession.

From Potential GDP to Structural Balance: A Theoretical Reassessment and New Evidence for Italy