Optimal Design of New Generation Fiscal Rules: Coping with the Business Cycle and Discretionary Tax Reductions

Abstract

While business cycles are crucial for determining the dynamics of government budget deficits, it is rare to find an analysis of optimal fiscal rules that are designed to cope with the asymmetric behavior of fiscal variables during the cycle. In this paper I characterize the dynamics of budget deficits along the cycle: i) in recessions marginal propensity to spend is higher than the coefficient of marginal tax revenues, causing an increase of the deficit over GDP; ii) in expansions tax revenues soar allowing for a deficit reduction; however, marginal spending is still high and consequently a full cycle implies an increase in the deficit. Then, I present a model in which fiscal rules are designed to cope with a political bias that is based on two components: the cyclical bias and discretionary tax reductions. According to my analysis, the new generation fiscal rules should be based on a combination of expenditure and revenue rules, which are newer than budget deficit rules and are becoming widespread. According to my empirically calibrated simulation, this combination of rules succeeds on avoiding the political bias and is more cycle-friendly than a budget deficit rule.1 Another source for political manipulations is tax exemptions, usually given to firms to avoid corporate taxes. Studying these changes is beyond the scope of the present paper. 2 Potentially V.A.T. reductions can be more popular than direct tax reductions since consumption is related to all individuals in society. However, a high income or corporate statutory tax reduction is more attractive for politicians than a small statutory V.A.T. reduction, because of two reasons: i) the visibility of the statutory tax reduction; ii) the income and corporate tax reduction can be targeted on the median voter. 3 See also Guichard et al. [13], who found that both expenditure and budget rules anchor successful fiscal consolidations. 4 Kopits [14] provides a list of arguments for and against budget rules.5 From a neo-classical point of view, balance budget rules may impose costs due to a sub-optimal path of tax rates [15].