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Fiscal Policy over the Real Business Cycle: A Positive Theory

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Marco Battaglini
Stephen Coate

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Abstract

This paper presents a political economy theory of the behavior of fiscal policy over the business cycle. The theory predicts that, in both booms and recessions, fiscal policies are set so that the marginal cost of public funds obeys a submartingale. In the short run, fiscal policy can be pro-cyclical with government debt spiking up upon entering a boom. However, in the long run, fiscal policy is counter-cyclical with debt increasing in recessions and decreasing in booms. Government spending increases in booms and decreases during recessions, while tax rates decrease during booms and increase in recessions. Data on tax rates from the G7 countries supports the submartingale prediction, and the correlations between fiscal policy variables and national income implied by the theory are consistent with much of the existing evidence from the U.S. and other countries.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14047.

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Date of creation: May 2008
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Handle: RePEc:nbr:nberwo:14047

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Find related papers by JEL classification:
D70 - Microeconomics - - Analysis of Collective Decision-Making - - - General
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
H60 - Public Economics - - National Budget, Deficit, and Debt - - - General

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Marco Battaglini & Thomas Palfrey, 2007. "The Dynamics of Distributive Politics," Discussion Papers 1451, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
    Other versions:
  2. Marco Bassetto, 2009. "The Research Agenda: Marco Bassetto on the Quantitative Evaluation of Fiscal Policy Rules," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 10(2), April. [Downloadable!]
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