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The Value of Constraints on Discretionary Government Policy
This paper investigates how institutional constraints discipline the behavior of discretionary governments subject to an expenditure bias. The focus is on constraints implemented in actual economies: monetary policy targets, limits on the deficit and debt ceilings. For a variety of aggregate shocks considered, the best policy is to impose a minimum primary surplus of about half a percent of output. Most welfare gains from constraining government behavior during normal times, which to a large extent is sufficient to discipline policy in adverse times. Monetary policy targets are not generally ...
How to Starve the Beast: Fiscal Policy Rules
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 ...
How to Starve the Beast: Fiscal and Monetary Policy Rules
Societies often rely on simple rules to restrict the size and behavior of governments. When fiscal and monetary policies are conducted by a discretionary and profligate government, I find that revenue ceilings vastly outperform debt, deficit and monetary rules, both in effectiveness at curbing public spending and welfare for private agents. However, effective revenue ceilings induce an increase in deficit, debt and inflation. Under many scenarios, including recurrent adverse shocks, the optimal ceiling on U.S. federal revenue is about 15% of GDP, which leads to welfare gains for private ...
Optimal Time-Consistent Taxation with Default
We study optimal time-consistent distortionary taxation when the repayment of government debt is not enforceable. The government taxes labor income or issues noncontingent debt in order to finance an exogenous stream of stochastic government expenditures. The government can repudiate its debt subject to some default costs, thereby introducing some state-contingency to debt. We are motivated by the fact that domestic sovereign default is an empirically relevant phenomenon, as Reinhart and Rogoff (2011) demonstrated. Optimal policy is characterized by two opposing incentives: an incentive to ...