Prepared by Gian Maria Milesi-Ferretti.
The neoclassical theory of fiscal policy can offer precise normative insights under the maintained assumption that distributional considerations can be addressed by lump-sum transfers. In reality, however, fiscal policies are used to redistribute resources across heterogeneous political groups and individuals, raising the question of how to define an appropriate benchmark of “virtuous” fiscal behavior. Clearly this is an open question, but for the purpose of this chapter we shall take as given the desirability of reducing fiscal imbalances.
A different, but related argument is made by Lizzeri (1999) in a game-theoretic model of redistributive politics. Uncertainty about the outcome of future elections implies that voters cannot predict whether politicians will in the future choose to redistribute resources to them. Voters are therefore favorable to politicians that promise them large current transfers, financing current expenditure through borrowing.
In Weingast, Shepsle and Johansen (1981) projects also bring political benefits to the district in which they are undertaken.
When spending decisions do not entail approval for all projects (as is the case, for example, when a minimum winning coalition decides on the projects to be undertaken), results are ambiguous and depend on the voting rule. In a dynamic setting, similar considerations can give rise to “excessive” fiscal deficits. Velasco (1999) emphasizes the bias in fiscal policy arising when government resources are “common property;” the tendency to run budget deficits arises because each group perceives the return on public savings to be too low, because the rate of return is adjusted by what other groups will appropriate. This enhances the tendency to overspend. Chari and Cole (1993a) show that a deficit bias can arise in the presence of political uncertainty, because accumulated government debt reduces the bias towards excess government spending, in a fashion similar to Persson and Svensson (1989) and Alesina and Tabellini (1990).
Some studies have examined the impact of rules in the absence of any underlying distortion in the conduct of fiscal policy. For example, Schmitt-Grohé and Uribe (1997) show that in a neoclassical growth model a balanced budget rule can make expectations of higher tax rates self-fulfilling if the fiscal authority relies on changes in labor income tax rates to balance the budget. This happens because the expectation of high tax rates lowers labor supply and therefore output, forcing tax rates to be raised to balance the budget.
In the context of monetary policy, an inflation bias can result from a credibility problem in the relation between the policy maker and the private sector. In the case of fiscal rules, instead, the relevant bias, as we have seen, can be determined by political and distributional factors; problems of time consistency can arise because current and future governments may have different preferences over social outcomes. Expectations over future electoral outcomes play an important role in shaping both policy decisions and voters’ electoral choices.
This point was often considered in the context of the Maastricht debate. Indeed, the move towards a common currency lowered borrowing costs for high-debt countries by removing inflation and exchange rate risk premia on interest rates. However, Bayoumi, Goldstein and Woglom (1995) find that U.S. states face a steeply rising supply curve for credit.
The nature of the trade-off between flexibility and deficit bias is apparent in some of the empirical work on the link between statutory fiscal restraints and budgetary outcomes within U.S. states. ACIR (1987) and von Hagen (1991), among others, find that states with such restraints run smaller budget deficits, while Bayoumi and Eichengreen (1995) find that the counter-cyclical responsiveness of state budgets is significantly reduced by more stringent balanced budget rules.
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