THE FISCAL COSTS OF DEBT LIMITS

Albert Marcet and Andrew Scott

No 378, Computing in Economics and Finance 2000 from Society for Computational Economics

Abstract: An increasing number of countries are investigating the desirability of placing fiscal policy under certain rules or constraints. The IMF has applauded and encouraged the idea of such fiscal framework as a way of transplanting the improvements that the last decade has seen in the operation of monetary policy to the area of fiscal policy. However, analysing and assessing the performance of a government's fiscal policy requires an understanding of both the objectives and constraints under which governments operate. As we show in this paper under different assumptions about the completeness or otherwise of financial markets the imposition of debt limits can affect adversely the optimality of fiscal policy making them undesirable for policy purposes. The aim of this paper is to discover the objectives and constraints within which OECD governments conduct their fiscal policy. Only once this has been determined is it possible to assess the validity of imposing debt or deficit ceilings.Our results suggest that in the absence of a complete set of contingent government securities that debt limits are unable to discriminate between bad fiscal authorities and good fiscal authorities which have been unlucky. Further our simulations suggest that debt limits of the magnitude suggested in practice lead to substantially higher tax volatility than is optimal.Under a wide range of models and assumptions about exogenous stochastic processes we show that an optimising fiscal authority will at times wish to achieve a substantial increase in debt levels.More precisely, under the maintained assumption of Ramsey fiscal policy, we show that the model of incomplete markets fits the VAR observations on government debt much better than the assumption of complete markets. This is true across a large array of various models. Hence, it would seem that the issue of debt limits should be analyzed under this framework.

Date: 2000-07-05
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