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Title: Fiscal Rules and Discretion under Limited Enforcement

Author(s): Marina Halac and Pierre Yared

Publication Date: December 2019

Keyword(s): deficit bias, Enforcement Constraints, Fiscal policy and private information

Programme Area(s): Macroeconomics and Growth and Public Economics

Abstract: We study a fiscal policy model in which the government is present-biased towards public spending. Society chooses a fiscal rule to trade off the benefit of committing the government to not overspend against the benefit of granting it flexibility to react to privately observed shocks to the value of spending. Unlike prior work, we examine rules under limited enforcement: the government has full policy discretion and can only be incentivized to comply with a rule via the use of penalties which are joint and bounded. We show that optimal incentives must be bang-bang. Moreover, under a distributional condition, the optimal rule is a maximally enforced deficit limit, triggering the largest feasible penalty whenever violated. Violation optimally occurs under high enough shocks if and only if available penalties are weak and such shocks are rare. If the rule is self-enforced in a dynamic setting, penalties take the form of temporary overspending.

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Bibliographic Reference

Halac, M and Yared, P. 2019. 'Fiscal Rules and Discretion under Limited Enforcement'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14218