Consistent Flexibility: Enforcement of Fiscal Rules Through Political Incentives

Abstract

We study the optimal design of a fiscal rule in a model in which the government is present-biased, shocks to tax revenues make rule compliance stochastic, and a rule violation reduces the payoff from holding office. We show that: i) the benchmark policy of the social planner can be always implemented via an optimal nonlinear fiscal rule and under certain conditions even under a linear rule; ii) the optimal rule prescribes a zero structural deficit but only partially accounts for shocks; and iii) a government with a stronger ex-ante deficit bias should be granted a higher degree of flexibility.

JEL Classification: D720, E610, H600