Working Paper: NBER ID: w25463
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 examine rules under limited enforcement: the government has full policy discretion and can only be incentivized to comply with a rule via the use of penalties which are joint and bounded. We show that optimal incentives must be bang-bang. Moreover, under a distributional condition, the optimal rule is a maximally enforced deficit limit, triggering the largest feasible penalty whenever violated. Violation optimally occurs under high enough shocks if and only if available penalties are weak and such shocks are rare. If the rule is self-enforced in a dynamic setting, penalties take the form of temporary overspending.
Keywords: fiscal rules; government discretion; limited enforcement; penalties; public spending
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 |
|---|---|
| optimal fiscal rule under limited enforcement (E62) | maximally enforced deficit limit (H62) |
| maximally enforced deficit limit violation (H62) | maximal penalty for the government (H81) |
| government’s present bias towards public spending (E62) | potential overspending (E62) |
| penalties (Z28) | potential overspending (E62) |
| violation of the fiscal rule under high shocks (E62) | weak penalties (K40) |
| distribution of shocks (D39) | enforcement of fiscal rules (E62) |