Deficit Limits and Fiscal Rules for Dummies
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Deficit Limits and Fiscal Rules for Dummies PAOLO MANASSE The paper shows that common fiscal rules, such as a limit to the deficit-output ratio, induce an ‘‘escape clause’’–type fiscal policy, similar to that studied for monetary policy by Flood and Isard (1988 and 1989) and Lohmann (1992): The government resorts to an active stabilization (for example, countercyclical) policy only during ‘‘exceptional times’’ by running deficits in recession phases and surpluses during economic booms. In contrast, it optimally chooses a procyclical policy in intermediate states of the economy, for example, by raising the budget deficit when output improves. Because the optimal fiscal reaction function in the presence of fiscal rules is not monotonous in output, the standard estimates that assume linearity are prone to a serious bias, and the conclusions on the pro- or countercyclical properties of fiscal policy found in the literature are likely to be unreliable. [JEL E61, E62, E63] IMF Staff Papers (2007) 54, 455–473. doi:10.1057/palgrave.imfsp.9450015
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his paper presents a very simple framework for discussing the effects of budget limits and fiscal rules on the conduct of fiscal policy. The literature on ‘‘fiscal frameworks’’ has expanded very rapidly in the past few years, possibly owing to the introduction of the Stability and Growth Pact (SGP) in Europe, the adoption of the ‘‘golden rule’’ in the United Kingdom, and the implementation of various fiscal rules and fiscal responsibility laws in many countries. Paolo Manasse is a professor of economics at the University of Bologna. This paper was written while he was a consultant at the IMF. The author wishes to thank Xavier Debrun, Bob Flood, Mohan Kumar, Antonio Spilimbergo, and participants at seminars at the IMF, Bocconi University, and Bologna University for suggestions and comments.
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Paolo Manasse
In a nutshell, all these frameworks aim to get rid of the ‘‘bathwater’’ of (politically motivated) excessive fiscal deficits without throwing away the ‘‘baby’’ of fiscal stabilization. But how should one achieve this objective? This paper attempts to clarify this issue by providing a simple framework for analyzing the effects of budget limits on the government’s incentive for fiscal discipline and their implication for stabilization policy. The paper shows that common fiscal rules, such as a limit to deficitoutput ratio, induce an ‘‘escape clause’’–type fiscal policy similar to that studied for monetary policy by Flood and Isard (1988 and 1989) and Lohmann (1992): The government resorts to an active stabilization (for example, countercyclical) policy only during ‘‘exceptional times’’ by running deficits in recession phases and surpluses during economic booms. In contrast, it optimally chooses a procyclical policy in intermediate states of the economy, for example, by raising the budget deficit when output improves. The analysis allows for a comparison between different budget rules and the characterization of the ‘‘optimal’’ fiscal rule. This optimal rule requires a mechanism by which the g
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