Starving the Leviathan: a Dynamic Analysis of Fiscal Constitutions

This paper analyzes the effects of imposing constitutional fiscal restraints in a dynamic political economy model of fiscal policy. Policy choices in each period are made by a legislature consisting of representatives elected by geographically-defined districts. The legislature uses distortionary taxation to finance a set of targeted transfers and the provision of a public good whose value is stochastic. The legislature can spread the cost of the shocks over time and smooth taxation by issuing one period risk free bonds. In the unrestrained equilibrium, the legislature will accumulate too much debt, inducing too much volatility in the policy variables, and under-provision of the public good. Imposing fiscal restraints may have the benefit of limiting the ability of the government to abuse its power. But it may also limit its flexibility in responding to shocks. The net effect depends on the fundamentals of the economy and the type of restraint being adopted. The model provides a framework to identify this trade off and evaluate quantitatively the cost of flexibility and the benefit of discipline. In a calibrated version of the model, we study the case for balanced budget requirements, debt limits and tax limits.