Working Paper: NBER ID: w22763
Authors: Samuel G. Hanson; David S. Scharfstein; Adi Sunderam
Abstract: In this paper, we develop a new model for government cost-benefit analysis in the presence of risk. In our model, a benevolent government chooses the scale of a risky project in the presence of two key frictions. First, there are market failures, which cause the government to perceive project payoffs differently than private households do. This gives the government a "social risk management" motive: projects that ameliorate market failures when household marginal utility is high are appealing. The second friction is that government financing is costly because of tax distortions. This creates a "fiscal risk management" motive: incremental spending that occurs when total government spending is already high is particularly unattractive. A first key insight is that the government's need to manage fiscal risk frequently limits its capacity for managing social risk. A second key insight is that fiscal risk and social risk interact in complex ways. When considering many potential projects, government cost-benefit analysis thus acquires the flavor of a portfolio choice problem. We use the model to explore how the relative attractiveness of two technologies for promoting financial stability—bailouts and regulation—varies with the government's fiscal burden and characteristics of the economy.
Keywords: Fiscal Risk; Government Programs; Cost-Benefit Analysis; Social Risk Management; Tax Distortions
JEL Codes: E61; G11; G28; H1; H43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government's capacity to manage social risk (H12) | Limited by its need to manage fiscal risk (H12) |
| High preexisting fiscal commitments (H69) | Less inclined to adopt programs like deposit insurance (G28) |
| Fiscal risk of any program (H68) | Dependent on how its outlays covary with those of other programs (H61) |
| Government decision-making regarding programs like deposit insurance (G28) | Reflects frictions and consequences on social and fiscal risks (H39) |