Working Paper: CEPR ID: DP12571
Authors: Marina Halac; Pierre Yared
Abstract: We study a fiscal policy model in which the government is present-biased towards public spending. Society chooses a fiscal rule to trade off the benefit of committing the government to not overspend against the benefit of granting it flexibility to react to privately observed shocks to the value of spending. Unlike prior work, we characterize rules that are self-enforcing: the government must prefer to comply with the rule rather than face the punishment that follows a breach, where any such punishment must also be self-enforcing. We show that the optimal rule is a maximally enforced deficit limit, which, if violated, leads to the worst punishment for the government. We provide a necessary and sufficient condition for the government to violate the deficit limit following sufficiently high shocks. Punishment takes the form of temporary overspending, after which the optimal rule is restored.
Keywords: self-enforcing rules; private information; fiscal policy; deficit bias
JEL Codes: C73; D02; D82; E6; H1; P16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deficit limit (H62) | government compliance (K23) |
| punishment for violating the rule (K40) | government overspending (H59) |
| government overspending (H59) | future punishments (K40) |
| severity of shocks (E71) | government compliance (K23) |
| design of fiscal rules (E62) | government spending behavior (H50) |