IV Fiscal Rules and the Effects of Fiscal Policy on Economic Activity

Abstract

In this section, the impact of fiscal policy on economic activity under discretion and under rules is investigated. More specifically, we ask whether fiscal rules imply a change in the behavioral reactions of economic agents to fiscal policy. To what degree can this happen? Private sector responses will be different if the same fiscal policy action today changes expectations for the path of fiscal policy tomorrow. In the discussion, which is conducted at a theoretical level because of data limitations, the focus will be “non-Keynesian” effects of fiscal policy, which depend crucially on expectations about future fiscal policy actions. 35 Three assumptions help highlight the potential differences between a rule-based and a discretionary fiscal regime:

In this section, the impact of fiscal policy on economic activity under discretion and under rules is investigated. More specifically, we ask whether fiscal rules imply a change in the behavioral reactions of economic agents to fiscal policy. To what degree can this happen? Private sector responses will be different if the same fiscal policy action today changes expectations for the path of fiscal policy tomorrow. In the discussion, which is conducted at a theoretical level because of data limitations, the focus will be “non-Keynesian” effects of fiscal policy, which depend crucially on expectations about future fiscal policy actions.35 Three assumptions help highlight the potential differences between a rule-based and a discretionary fiscal regime:

  • Fiscal rules are binding and credible. The rationale for this assumption is straightforward: if rules are neither binding nor credible, the difference between a rules-based and a discretionary regime vanishes.

  • Under discretion, governments have biases in the direction of higher spending and higher deficits. This assumption ensures that there is a rationale for fiscal rules. In addition, the presence of “biases” under a discretionary regime ensures that future government behavior, and hence private sector expectations, will be different under rules from discretion.

  • The government’s intertemporal budget constraint is always binding. This third assumption simply ensures that the public internalizes the fact that the government must eventually repay its debts. Under discretion and in the presence of a deficit bias this may happen later rather than sooner, but inevitably it does happen.

Two types of fiscal rules will be considered: a rule on the cyclically adjusted budget balance and an expenditure rule.36 We shall focus first on temporary tax and spending “shocks” and subsequently on announced permanent changes in policy. The analysis is mainly concerned with the impact of fiscal policy on aggregate demand37 in a small, open economy.38 Fiscal rules may have additional effects related to their impact on uncertainty. For example, binding limits on fiscal imbalances will reduce, other things being equal, the likelihood of higher future taxes, with positive effects on capital accumulation.39 Investment may also be positively affected by the reduction in the volatility of fiscal policy that rules may entail.

The results of the analysis, presented in more detail in Appendix IV, can be summarized as follows. Announcements of permanent changes in fiscal policy may be more credible if they are supported by rules. This would make private agents more likely to respond to a spending or tax cut by raising their private consumption as they anticipate a reduction in their future tax burden. By contrast, private agents under discretion may believe that reductions in spending will only be temporary (given the assumed spending bias of the government). They therefore would raise their private consumption less in response to either tax or spending cuts. Accordingly, a permanent spending cut may be less contractionary and a permanent tax cut may be more expansionary under rules than under discretion.

For the case of temporary fiscal shocks, the key issues are whether the shock will be offset by changes in taxes or in expenditure, and whether this offset is going to take place sooner rather than later. Under rules, deviations from the announced path generally reverse sooner rather than later, implying weaker effects of tax reductions on aggregate demand. The private sector response to a spending increase may instead differ between the case of a spending rule (making it likely that the offset is going to occur through lower future spending) or a deficit rule (the offset could occur with an increase in future taxes, similar to the case of discretion). Aggregate demand would therefore rise more under a spending rule because agents anticipate that the increase in public absorption is temporary.

To summarize, once fiscal rules are in place, are understood by the public, and have become credible, the impact of fiscal policy changes on aggregate demand may differ relative to a framework of discretion, because rules may change the public’s perception of how future fiscal policy will evolve. For example, with a spending rule, a discretionary tax cut is likely to be more expansionary than under discretion if permanent but less so if temporary. A permanent spending cut, on the other hand, may be less contractionary, while a temporary spending increase is likely to be more expansionary. Of course, while the theory suggests that these might be the effects, whether they are large enough for policymakers to take them into account in practice is an empirical matter.

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