Why 3% for budget deficit?

[Charles123]

Main Question or Discussion Point

Why does the EU Stability and Growth Pact sets the specific value of 3% of GDP for maximum budget deficit. Where does the number come from? Why specifically 3% instead of 2.5% or 3.5%?
Thank you
regards

 

[russ_watters]

I don't have an actual reference, but it is probably tied to the average historical inflation rate. A deficit equal to the inflation rate is doesn't result in a growing debt over time.

 

[Charles123]

Can you please explain your thought?
Thank you
Regards

 

[Alesak]

I'd say it's 3% and not something near it because it's nicely rounded number. For real reason: if you have inflation 3% (i.e. 3% higher prices and wages) you get more taxes (since tax is % of wages etc.) and therefore can pay for more debt. So inflation increases your nominal revenue.

Another factor in sustainable deficit is GDP growt, so when you add inflation and GDP growth you get about 5% sustainable deficit.

 

[Charles123]

Thank you for your reply.
I wasn’t thinking about wages being adjusted to inflation and therefore inflation adding in tax revenue (wages tax + VAT), and therefore the value of dept you can pay is constant, assuming no GDP growth.
About GDP growth, what you are saying is that the 3% instead of 5% is a safeguard against no growth?
regards

 

[JonDE]

Another factor in sustainable deficit is GDP growt, so when you add inflation and GDP growth you get about 5% sustainable deficit.

Actually, you and Russ are thinking about this slightly wrong. If you match debt growth to GDP growth, your debt levels will rise, if they are less then 100% of GDP. If they are over 100% they will actually shrink. The obvious way of thinking about this is take a country with no debt and a 3% deficit for the year and 3% inflation, obviously their debt levels would have to rise from 0.

p.s. in Russ's case he actually did say specifically for inflation, which depending on the case, may or may not lead to an increase in debt levels.

 

[Czcibor]

Why does the EU Stability and Growth Pact sets the specific value of 3% of GDP for maximum budget deficit. Where does the number come from? Why specifically 3% instead of 2.5% or 3.5%?
Thank you
regards

Purely arbitrary number. Origin: it was already selected earlier when the EU zone was formed as requirement, now this value is merely reinforced.