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Enrichments to Multi-Year Fiscal Commitments in the Presence of Uncertainty

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  • Patrick Georges
  • Nicolas Moreau

Abstract

Firstly, the study illustrates in a stochastic simulation model that permanent commitments to tax and spending measures can be enriched significantly without substantially raising the risk of a deficit outcome. This result is obtained in a framework where the fiscal authority is able to monitor the origin of the economic shocks and has model-consistent expectations. Secondly, this paper evaluates whether the knowledge of the origin and persistence of the economic shocks is a key element driving this conclusion. To do this, we add to the economic uncertainty, uncertainty about the "true" persistence of the shocks and gauge whether, in that context dubbed "model uncertainty", our strategy can still enhance the fiscal authority’s pre-commitment to permanent measures without substantially increasing the risk of a deficit outcome. We conclude that, as time goes on, the fiscal authority may find that it has been too optimistic in enhancing its permanent commitments (i.e., these additional permanent fiscal measures may increase the probability of a deficit outcome). This illustrates the difficulties of making decisions under uncertainty and the potential cost of making mistakes. This also suggests the importance of prudent behavior when committing to long-term fiscal initiatives. Our conclusion, however, depends on the way the total uncertainty facing the fiscal authority is controlled, and on other factors such as the calibration of our model and the ability of learning of the fiscal authority. Model uncertainty may well have less effect at medium-term horizons when these considerations are introduced. Dans un premier temps nous montrons dans un modèle de simulation stochastique que si l’autorité budgétaire est capable d’observer l’origine des chocs économiques et a des attentes consistantes avec le modèle, des mesures budgétaires permanentes et substantielles peuvent alors être introduites sans créer une augmentation importante du risque de déficit budgétaire. Ensuite, afin d’évaluer si ce résultat est sensible à la connaissance de l’origine et de la persistance des chocs, nous ajoutons à l’incertitude économique l’incertitude quant à la "vraie" persistance des chocs et estimons si, dans ce contexte appelé «incertitude de modèle», il est toujours possible d’enrichir les engagements permanents sans augmenter substantiellement le risque de déficit budgétaire. Nous concluons que l’autorité budgétaire peut, dans le moyen terme, se rendre compte qu’elle a sur-réagit dans ses enrichissements d’engagements permanents, c’est-à-dire, que ces enrichissements sont accompagnés d’une hausse de la probabilité de déficit budgétaire. Ceci illustre les difficultés de la prise de décision dans un contexte d’incertitude, le coût potentiel de faire des erreurs, et l’importance d’un comportement prudent face aux engagements permanents. Nos conclusions dépendent du contrôle du contexte d’incertitude totale dans lequel l’autorité budgétaire opère, et d’autres facteurs comme le calibrage du modèle et la capacité d’apprentissage de l’autorité budgétaire. La sur-réaction dans les enrichissements d’engagements permanents peut être réduite lorsque ces considérations sont prises en compte.

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Bibliographic Info

Paper provided by Department of Finance Canada in its series Working Papers-Department of Finance Canada with number 2002-11.

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Handle: RePEc:fca:wpfnca:2002-11

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Cited by:
  1. Hostland, Doug & Karam, Philippe, 2006. "Assessing debt sustainability in emerging market economies using stochastic simulation methods," Policy Research Working Paper Series 3821, The World Bank.

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