How to Starve the Beast: Fiscal Policy Rules

Martin, Fernando M.

doi:10.20955/wp.2019.026

Working Paper Revision

How to Starve the Beast: Fiscal Policy Rules

Abstract: Countries have widely imposed fiscal rules designed to constrain government spending and ensure fiscal responsibility. This paper studies the effectiveness and welfare implications of revenue, deficit and debt rules when governments are discretionary and profligate. The optimal prescription is a revenue ceiling coupled with a balance budget requirement. For the U.S., the optimal revenue ceiling is about 15% of output, 3 percentage points below the postwar average, and yields welfare gains equivalent to 10% of consumption. Most of the benefits can still be reaped with a milder constraint or escape clauses during adverse times. Imposing a single fiscal rule allows governments to comply without necessarily curbing spending; on their own, revenue ceilings are only mildly effective, while deficit and debt rules are altogether ineffective.

Keywords: time-consistency; fiscal rules; discretion; government debt; deficit; institutional design; political frictions; austerity; debt sustainability;

JEL Classification: E52; E58; E61; E62;

https://doi.org/10.20955/wp.2019.026