Working Paper: NBER ID: w18545
Authors: Marina Halac; Pierre Yared
Abstract: This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time-inconsistent preferences with a present-bias towards public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have flexibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under i.i.d. shocks, we show that the ex-ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex-ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future fiscal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run.
Keywords: Fiscal Rules; Policy Discretion; Persistent Shocks; Public Spending
JEL Codes: 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 |
|---|---|
| high shocks (E32) | reduced fiscal discipline (H69) |
| reduced fiscal discipline (H69) | future fiscal capabilities (E62) |
| low shocks (Q43) | reinstated fiscal discipline (H61) |
| dynamic incentives (O31) | avoidance of overspending and overborrowing (G51) |
| fiscal rule design (E62) | long-term economic health (E66) |