Fiscal Rules and Discretion under Self-Enforcement

Marina Halac and Pierre Yared

No 12571, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 temporary overspending, after which the optimal rule is restored.

Keywords: Self-enforcing rules; Private information; Fiscal policy; Deficit bias (search for similar items in EconPapers)
JEL-codes: C73 D02 D82 E6 H1 P16 (search for similar items in EconPapers)
Date: 2018-01
New Economics Papers: this item is included in nep-mac
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Working Paper: Fiscal Rules and Discretion under Self-Enforcement (2018)
Working Paper: Fiscal Rules and Discretion under Self-Enforcement (2017)
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