Fiscal Rules and Discretion Under Self-Enforcement

58 Pages Posted: 9 Oct 2017 Last revised: 9 Nov 2024

See all articles by Marina Halac

Marina Halac

Columbia University

Pierre Yared

Columbia University - Columbia Business School, Finance

Multiple version iconThere are 2 versions of this paper

Date Written: October 2017

Abstract

We study a fiscal policy model in which the government is present-biased towards public spending. Society chooses a fiscal rule to trade off the benefit of committing the government to not overspend against the benefit of granting it flexibility to react to privately observed shocks to the value of spending. Unlike prior work, we characterize rules that are self-enforcing: the government must prefer to comply with the rule rather than face the punishment that follows a breach, where any such punishment must also be self-enforcing. We show that the optimal rule is a maximally enforced deficit limit, which, if violated, leads to the worst punishment for the government. We provide a necessary and sufficient condition for the government to violate the deficit limit following sufficiently high shocks. Punishment takes the form of a maximally enforced surplus limit that incentivizes overspending; fiscal discipline is restored when the government respects it.

Suggested Citation

Halac, Marina and Yared, Pierre, Fiscal Rules and Discretion Under Self-Enforcement (October 2017). NBER Working Paper No. w23919, Available at SSRN: https://ssrn.com/abstract=3049765

Marina Halac (Contact Author)

Columbia University ( email )

Pierre Yared

Columbia University - Columbia Business School, Finance ( email )

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