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Prudent Budgetary Policy: Political Economy of Precautionary Taxation

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  • Frederick van der Ploeg

Abstract

The theory of tax smoothing and determination of public debt with uncertain future national income is extended for prudence. A prudent government deliberately underestimates future national income and the tax base, especially if the variance and persistence of shocks hitting the tax base are large and the tax rate and the unemployment benefit are large. As a precaution the tax rate is set higher and the level of public spending lower. As a result, as income and the tax base turn out to be bigger than budgeted, the minister of finance enjoys windfall revenues and is able to gradually reduce debt and debt service over time. This permits, depending on political preferences, either gradual cuts in the tax rate, gradual increases in government spending or a combination of both. It is easy to allow for government assets as well. Finally, political economy justifications are offered of why it is desirable to appoint a strong and pessimistic minister of finance. In particular, we show that prudence is able to offset the intertemporal spending, tax and debt biases resulting from the common-pool distortions. If the minister of finance and the prime minister are given as many voting rights as the spending ministers combined, the intratemporal common-pool distortions of an excessively large public sector are eliminated as well. A strong and pessimistic minister of finance can thus control the impatient profligacy of squabbling spending ministers. However, if voters care about outcomes on election eve, prudence may be abused for short-run electoral gains. Opportunistic manipulation of election results, however, also dampens the intertemporal common-pool distortions.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1973.

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Date of creation: 2007
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Handle: RePEc:ces:ceswps:_1973

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Keywords: prudence; pessimism; precautionary taxation; tax smoothing; public debt; income forecasts; public sector assets; common pool; feedback Nash; voting rights; electoral budget cycles; political economy;

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  1. Ahmed, S. & Rogers, J.H., 1993. "Government Budget Deficits and Trade Deficits: Are Present Value Constraints Satisfied in Long-Term Data?," Papers, Pennsylvania State - Department of Economics 5-93-6, Pennsylvania State - Department of Economics.
  2. Mark Hallerberg & Jurgen von Hagen, 1997. "Electoral Institutions, Cabinet Negotiations, and Budget Deficits in the European Union," NBER Working Papers 6341, National Bureau of Economic Research, Inc.
  3. van der Ploeg, Frederick, 1993. "A Closed-Form Solution for a Model of Precautionary Saving," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 60(2), pages 385-95, April.
  4. Miles S. Kimball, 1989. "Precautionary Saving in the Small and in the Large," NBER Working Papers 2848, National Bureau of Economic Research, Inc.
  5. Nordhaus, William D, 1975. "The Political Business Cycle," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 42(2), pages 169-90, April.
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  7. International Monetary Fund, 1996. "Budget Processes and Commitment to Fiscal Discipline," IMF Working Papers 96/78, International Monetary Fund.
  8. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 100(4), pages 1169-89, November.
  9. Bharat Trehan & Carl E. Walsh, 1987. "Common trends, the government's budget constraint, and revenue smoothing," Working Papers in Applied Economic Theory 87-11, Federal Reserve Bank of San Francisco.
  10. Swank, Otto H, 2002. " Budgetary Devices for Curbing Spending Prone Ministers and Bureaucrats," Public Choice, Springer, Springer, vol. 111(3-4), pages 237-57, June.
  11. Henning Bohn, 1998. "The Behavior Of U.S. Public Debt And Deficits," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 113(3), pages 949-963, August.
  12. Louis Eeckhoudt & Christian Gollier, 2005. "The impact of prudence on optimal prevention," Economic Theory, Springer, Springer, vol. 26(4), pages 989-994, November.
  13. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  14. Antoine Bommier, 2001. "Uncertain lifetime and intertemporal choice : risk aversion as a rationale for time discounting," Research Unit Working Papers, Laboratoire d'Economie Appliquee, INRA 0108, Laboratoire d'Economie Appliquee, INRA.
  15. Velasco, Andres, 2000. "Debts and deficits with fragmented fiscal policymaking," Journal of Public Economics, Elsevier, Elsevier, vol. 76(1), pages 105-125, April.
  16. Antonio Afonso, 2004. "Fiscal Sustainability: the Unpleasant European Case," Money Macro and Finance (MMF) Research Group Conference 2004, Money Macro and Finance Research Group 57, Money Macro and Finance Research Group.
  17. Bohn, Henning, 2007. "Are stationarity and cointegration restrictions really necessary for the intertemporal budget constraint?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(7), pages 1837-1847, October.
  18. Torsten Persson & Guido Tabellini, 2002. "Political Economics: Explaining Economic Policy," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262661314, December.
  19. Kenneth Rogoff, 1987. "Equilibrium Political Budget Cycles," NBER Working Papers 2428, National Bureau of Economic Research, Inc.
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Cited by:
  1. Ouattara, Bazoumana & Amegashie, J. Atsu & Strobl, Eric, 2009. "Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid," Proceedings of the German Development Economics Conference, Frankfurt a.M. 2009 24, Verein für Socialpolitik, Research Committee Development Economics.
  2. Thomas Moutos & Christos Tsitsikas, 2010. "Whither Public Interest: The Case of Greece's Public Finances," CESifo Working Paper Series 3098, CESifo Group Munich.
  3. International Monetary Fund, 2011. "Fiscal Expectations Under the Stability and Growth Pact," IMF Working Papers 11/48, International Monetary Fund.
  4. Marcos Poplawski-Ribeiro & Jan-Christoph Rülke, 2010. "Fiscal Expectations on the Stability and Growth Pact: Evidence from Survey Data," Working Papers 2010-05, CEPII research center.

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