Fiscal Rules and Discretion Under Limited Enforcement

53 Pages Posted: 19 Jan 2019

See all articles by Marina Halac

Marina Halac

Columbia University

Pierre Yared

Columbia University - Columbia Business School, Finance

Date Written: January 9, 2019

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 examine rules under limited enforcement: the government has full policy discretion and can only be incentivized to comply with a rule via the use of penalties which are joint and bounded. We show that optimal incentives must be bang-bang. Moreover, under a distributional condition, the optimal rule is a maximally enforced deficit limit, triggering the largest feasible penalty whenever violated. Violation optimally occurs under high enough shocks if and only if available penalties are weak and such shocks are rare. If the rule is self-enforced in a dynamic setting, penalties take the form of temporary overspending.

Keywords: Private Information, Fiscal Policy, Deficit Bias, Enforcement Constraints

JEL Classification: C73, D02, D82, E6, H1, P16

Suggested Citation

Halac, Marina and Yared, Pierre, Fiscal Rules and Discretion Under Limited Enforcement (January 9, 2019). Columbia Business School Research Paper Forthcoming, Available at SSRN: https://ssrn.com/abstract=3312974 or http://dx.doi.org/10.2139/ssrn.3312974

Marina Halac

Columbia University ( email )

Pierre Yared (Contact Author)

Columbia University - Columbia Business School, Finance ( email )

3022 Broadway
Uris Hall
New York, NY 10027
United States

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