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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.

Suggested Citation

  • Frederick Van der Ploeg, 2007. "Prudent Budgetary Policy: Political Economy of Precautionary Taxation," CESifo Working Paper Series 1973, CESifo Group Munich.
  • Handle: RePEc:ces:ceswps:_1973
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    References listed on IDEAS

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    Cited by:

    1. 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.
    2. Amegashie, J. Atsu & Ouattara, Bazoumanna & Strobl, Eric, 2007. "Moral Hazard and the Composition of Transfers: Theory with an Application to Foreign Aid," MPRA Paper 3158, University Library of Munich, Germany, revised 06 May 2007.
    3. Thomas Moutos & Christos Tsitsikas, 2010. "Whither Public Interest: The Case of Greece's Public Finances," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, vol. 66(2), pages 170-206, June.
    4. Marcos Poplawski-Ribeiro & Jan-Christoph Rülke, 2011. "Fiscal Expectations Under the Stability and Growth Pact; Evidence from Survey Data," IMF Working Papers 11/48, International Monetary Fund.

    More about this item

    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;

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H60 - Public Economics - - National Budget, Deficit, and Debt - - - General

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