Flexibility of Deficit Ceiling and Income Fluctuation

To avoid fiscal crisis, a government can impose a long-term deficit ceiling. A key issue that has arisen with respect to this is how long-term objectives should be modified to accommodate economic fluctuations and to maintain some flexibility with respect to fiscal stabilization policy in a political economy. By incorporating the political efforts of private agents into a simple model, we explore how income fluctuations affect the deficit ceiling in a political economy. If the government can optimally impose a deficit ceiling, normally, the deficit ceiling should rise in a recession as a first-best case; however, interestingly, a recession does not necessarily prompt an increase in the deficit ceiling in the second-best case. The response of the optimal deficit ceiling to income fluctuations mainly depends on the effect of fiscal privileges on the marginal benefit of useful public spending and on the extent of political effort.