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Fiscal Rules and Discretion under Persistent Shocks

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  • Marina Halac
  • Pierre Yared

Abstract

This paper studies the optimal level of discretion in policymaking. We consider a fiscal policy model where the government has time-inconsistent preferences with a present-bias towards public spending. The government chooses a fiscal rule to trade off its desire to commit to not overspend against its desire to have flexibility to react to privately observed shocks to the value of spending. We analyze the optimal fiscal rule when the shocks are persistent. Unlike under i.i.d. shocks, we show that the ex-ante optimal rule is not sequentially optimal, as it provides dynamic incentives. The ex-ante optimal rule exhibits history dependence, with high shocks leading to an erosion of future fiscal discipline compared to low shocks, which lead to the reinstatement of discipline. The implied policy distortions oscillate over time given a sequence of high shocks, and can force the government to accumulate maximal debt and become immiserated in the long run.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18545.

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Date of creation: Nov 2012
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Publication status: published as Fiscal Rules and Discretion Under Persistent Shocks Marina Halac1,2 andPierre Yared1,3,† Article first published online: 3 OCT 2014 DOI: 10.3982/ECTA11207 © 2014 The Econometric Society Issue Econometrica Econometrica Volume 82, Issue 5, pages 1557–1614, September 2014
Handle: RePEc:nbr:nberwo:18545
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Find related papers by JEL classification:
  • D02 - Microeconomics - - General - - - Institutions: Design, Formation, Operations, and Impact
  • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
  • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook
  • H1 - Public Economics - - Structure and Scope of Government
  • P16 - Economic Systems - - Capitalist Systems - - - Political Economy of Capitalism

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  1. Battaglini, Marco & Coate, Stephen, 2007. "A Dynamic Theory of Public Spending, Taxation and Debt," Working Papers 07-04, Cornell University, Center for Analytic Economics.
  2. Pierre Yared, 2010. "Politicians, Taxes and Debt," Review of Economic Studies, Oxford University Press, vol. 77(2), pages 806-840.
  3. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  4. Bruno Strulovici, 2011. "Renegotiation-Proof Contracts with Moral Hazard and Persistent Private Information," Discussion Papers 1519, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  5. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Oxford University Press, vol. 71(4), pages 1217-1239.
  6. Alberto Alesina & Roberto Perotti, 1994. "The Political Economy of Budget Deficits," NBER Working Papers 4637, National Bureau of Economic Research, Inc.
  7. Ricardo J. Caballero & Pierre Yared, 2008. "Future Rent-Seeking and Current Public Savings," NBER Working Papers 14417, National Bureau of Economic Research, Inc.
  8. Alessandro Lizzeri, 1999. "Budget Deficits and Redistributive Politics," Review of Economic Studies, Oxford University Press, vol. 66(4), pages 909-928.
  9. Kocherlakota, Narayana R., 1996. "Reconsideration-Proofness: A Refinement for Infinite Horizon Time Inconsistency," Games and Economic Behavior, Elsevier, vol. 15(1), pages 33-54, July.
  10. Marina Azzimonti, 2011. "Barriers to Investment in Polarized Societies," American Economic Review, American Economic Association, vol. 101(5), pages 2182-2204, August.
  11. Alberto Alesina & Guido Tabellini, 1990. "A Positive Theory of Fiscal Deficits and Government Debt," Review of Economic Studies, Oxford University Press, vol. 57(3), pages 403-414.
  12. Manuel Amador & Ivan Werning & George-Marios Angeletos, 2003. "Commitment Vs. Flexibility," NBER Working Papers 10151, National Bureau of Economic Research, Inc.
  13. Thomas, Jonathan & Worrall, Tim, 1990. "Income fluctuation and asymmetric information: An example of a repeated principal-agent problem," Journal of Economic Theory, Elsevier, vol. 51(2), pages 367-390, August.
  14. Marek Kapicka, 2013. "Efficient Allocations in Dynamic Private Information Economies with Persistent Shocks: A First-Order Approach," Review of Economic Studies, Oxford University Press, vol. 80(3), pages 1027-1054.
  15. Marina, Azzimonti & Marco, Battaglini & Stephen, Coate, 2010. "On the Case for a Balanced Budget Amendment to the U.S. Constitution," MPRA Paper 25935, University Library of Munich, Germany.
  16. Mikhail Golosov & Aleh Tsyvinski, 2006. "Designing Optimal Disability Insurance: A Case for Asset Testing," Journal of Political Economy, University of Chicago Press, vol. 114(2), pages 257-279, April.
  17. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  18. repec:fth:starer:8415 is not listed on IDEAS
  19. Gary Chamberlain & Charles A. Wilson, 2000. "Optimal Intertemporal Consumption Under Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(3), pages 365-395, July.
  20. Marina Halac, 2012. "Relational Contracts and the Value of Relationships," American Economic Review, American Economic Association, vol. 102(2), pages 750-79, April.
  21. Laibson, David I., 1997. "Golden Eggs and Hyperbolic Discounting," Scholarly Articles 4481499, Harvard University Department of Economics.
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Cited by:

  1. Alberto Alesina & Andrea Passalacqua, 2015. "The Political Economy of Government Debt," NBER Working Papers 21821, National Bureau of Economic Research, Inc.
  2. Bowen, T. Renee & Chen, Ying & Eraslan, Hulya & Zapal, Jan, 2015. "Efficiency of Flexible Budgetary Institutions," Research Papers 3185, Stanford University, Graduate School of Business.
  3. WAKI Yuichiro & Richard DENNIS & FUJIWARA Ippei, 2015. "The Optimal Degree of Monetary-Discretion in a New Keynesian Model with Private Information," Discussion papers 15007, Research Institute of Economy, Trade and Industry (RIETI).
  4. Rodrigo Harrison & Roger Lagunoff, 2013. "Dynamic Mechanism Design for a Global Commons," Documentos de Trabajo 442, Instituto de Economia. Pontificia Universidad Católica de Chile..
  5. Désirée Christofzik & Sebastian Kessing, 2014. "Does Fiscal Oversight Matter?," CESifo Working Paper Series 5023, CESifo Group Munich.
  6. Falilou Fall & Debra Bloch & Jean-Marc Fournier & Peter Hoeller, 2015. "Prudent debt targets and fiscal frameworks," OECD Economic Policy Papers 15, OECD Publishing.
  7. Marina Azzimonti & Marco Battaglini & Stephen Coate, 2015. "The Costs and Benefits of Balanced Budget Rules: Lessons from a Political Economy Model of Fiscal Policy," Department of Economics Working Papers 15-03, Stony Brook University, Department of Economics.
  8. Facundo Piguillem & Alessandro Riboni, 2015. "Spending-Biased Legislators: Discipline Through Disagreement," The Quarterly Journal of Economics, Oxford University Press, vol. 130(2), pages 901-949.
  9. Alexandre B. Cunha & Emanuel Ornelas, 2014. "Political competition and the limits of political compromise," LSE Research Online Documents on Economics 60273, London School of Economics and Political Science, LSE Library.
  10. Marina Halac & Pierre Yared, 2015. "Fiscal Rules and Discretion in a World Economy," NBER Working Papers 21492, National Bureau of Economic Research, Inc.
  11. Lizzeri, Alessandro & Yariv, Leeat, 2015. "Collective Self Control," CEPR Discussion Papers 10458, C.E.P.R. Discussion Papers.
  12. R. Vijay Krishna & Shiming Fu, 2016. "Dynamic Financial Contracting with Persistent Private Information," 2016 Meeting Papers 89, Society for Economic Dynamics.

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