Working Paper: NBER ID: w23919
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 a maximally enforced surplus limit that incentivizes overspending; fiscal discipline is restored when the government respects it.
Keywords: Fiscal Rules; Government Spending; Self-Enforcement
JEL Codes: C73; D02; D82; E61; P16
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Structure of fiscal rules (E62) | Government compliance (K23) |
| Threat of punishment (K42) | Government behavior (H11) |
| High shocks (C69) | Breach of deficit limit (H62) |
| Self-enforcement mechanisms (P14) | Compliance with fiscal rule (E62) |
| Continuation values (J17) | Government spending behavior (H59) |
| Government spending decisions (H61) | Society welfare (I30) |