Consistent Flexibility: Enforcement of Fiscal Rules Through Political Incentives

54 Pages Posted: 28 Jul 2020

See all articles by Valerio Dotti

Valerio Dotti

Washington University in St. Louis

Eckhard Janeba

University of Mannheim - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute)

Date Written: 2020

Abstract

We study a fiscal policy model in which the government is present-biased, leading to an excessive public deficit. An optimally designed fiscal rule needs to trade off the benefit of committing the government to not overspend against the benefit of granting it flexibility to react to shocks to tax revenues. Unlike prior work, we characterize a rule that is enforced through political incentives: the punishment for a violation of the rule consists in a reduction of the politician's payoff from being in office during the following period. We show that the optimal fiscal rule prescribes a zero structural deficit and only partially accounts for revenue shocks. Moreover - and somewhat surprising - a government with a stronger ex ante deficit bias should be granted a higher degree of flexibility. Flexibility leads to more rather than less fiscal discipline because the punishment for a rule violation is less driven by luck and more dependent on actual policy choices. Thus a trade-off between fiscal discipline and fiscal rule flexibility, as often claimed in the context of the EU's Stability and Growth Pact, does not typically exist in our model.

JEL Classification: D720, E610, H600

Suggested Citation

Dotti, Valerio and Janeba, Eckhard, Consistent Flexibility: Enforcement of Fiscal Rules Through Political Incentives (2020). CESifo Working Paper No. 8440, Available at SSRN: https://ssrn.com/abstract=3657976

Valerio Dotti (Contact Author)

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

Eckhard Janeba

University of Mannheim - Department of Economics ( email )

L7, 3-5
D-68131 Mannheim
Germany

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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