Working Paper: CEPR ID: DP16211
Authors: Chiara Felli; Facundo Piguillem; Liyan Shi
Abstract: It is widely believed that governments tend to overaccumulate debt, which gives rise to the need for fiscal rules. This paper studies the optimal fiscal and default rules when governments can default on their debt obligations. We build a continuous-time model that encompasses the standard rationale for debt overaccumulation: hyperbolic discounting and political economy frictions. In addition, governments are subject to taste shocks, which makes spending optimally random. Since shocks are private information, there is a trade-off between rules and discretion. We derive the optimal fiscal rules which are debt-dependent only when default is possible. Depending on the severity of the spending bias and the cost of default, the optimal fiscal rules range from strict debt limits, complemented by strong deficit limits, to the absence of all rules. In intermediate cases, debt-dependent deficit limits must be complemented with default rules, with some areas where default is banned and others where default is mandatory.
Keywords: spending bias; fiscal rules; government debt; sovereign default
JEL Codes: E6; E62; H1; H6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| potential for government default (H63) | design of optimal fiscal rules (E63) |
| government debt (H63) | design of optimal fiscal rules (E63) |
| government debt (H63) | stricter fiscal rules (E62) |
| default rules (Y20) | fiscal rules (E62) |
| severity of spending bias (D91) | necessity and type of fiscal rules (E62) |
| political economy frictions (P19) | government spending behavior (H50) |
| default rules (Y20) | government spending behavior (H50) |