Fiscal illusion and the demand for government expenditures in the UK

This paper examines whether variables commonly used to test standard fiscal illusion arguments (that tax structure affects voters' demands for public goods) can help explain the time-series behaviour of government expenditure in the UK during 1955–1994. We modify a standard median voter model to incorporate fiscal illusion via ‘less visible' (indirect) taxes and deficit financing. While we find evidence that both are positively associated with increased government spending, this would appear to be consistent with both fiscal illusion and standard efficiency arguments.     

A dynamic model of fiscal reconstruction

This paper investigates dynamic properties of fiscal reconstruction by analyzing the infinite duration differential game among interest groups with a framework of voluntary acceptance of tax burden. By comparing the first-best solution of fiscal reconstruction, the open-loop Nash equilibrium path, and the feedback Nash equilibrium path, we highlight the free-riding behavior of interest groups in the process of fiscal reconstruction. We derive explicitly the target levels of government debt and primary expenditures, and the adjustment speed of fiscal reconstruction under the respective solutions. We also examine the impacts of consumption taxes on their adjustment speeds as well as long-run outcomes of the respective paths.     

When is fiscal adjustment an illusion?

Fiscal adjustment is an illusion when it lowers the budget deficit or public debt but leaves government net worth unchanged. Conventional measures of the budget deficit largely show the change in public sector debt. Ideally, the measured deficit would reflect the change in public sector net worth. Many people consider it impractical to try to measure public sector assets. My paper does not discuss what the deficit should measure, but instead proposes a positive and testable theory of how governments actually behave.
When an outside agent forces a reduction in a government's conventional deficit and debt accumulation, the government responds by lowering asset accumulation or increasing hidden liabilities. Since government net worth is unchanged, such fiscal adjustment is an illusion. Using data from countries with World Bank and IMF fiscal adjustment programmes, and case studies of EMU countries' compliance with the Maastricht criteria, I confirm my theoretical predictions: fiscal adjustment in these countries was at least partly an illusion.     

Ricardian equivalence and fiscal distortions in the Dominican Republic

This paper tests the Ricardian equivalence hypothesis in the context of the Dominican Republic (DR). The results rejected the Ricardian theorem but a weaker version is shown to have significant implications for the DR. If the government borrows to increase spending, private consumption is crowded out and the economy will suffer in the long run. The outcome is worst if the government borrows to deliver a tax cut. In particular, for every RD$ 1.00 of additional debt incurred to finance government primary spending, private consumption and gross domestic product (GDP) fall by a meaningful RD$ 2.15 and RD$ 1.15 respectively. If the debt is used to finance the tax cut, the fall is RD$ 2.15 in both consumption and output. Interestingly, if the government uses taxes to cover a budget deficit, the effect is neutral and consistent with Ricardian equivalence. The paper argues that fiscal distortions are in part responsible for these multipliers. Distortions are estimated to be 21 % coming from different sources including taxes evasion and fiscal drainage. These findings suggest that the DR could benefit from either reducing the level of fiscal distortions or the size and scope of the Dominican government. If, however, the government continues to pursue an active fiscal role under the current environment, it will generate an unnecessary burden to consumption and economic growth.     

Automatic stabilizers, fiscal rules and macroeconomic stability

This paper analyzes the effect of the fiscal structure upon the trade-off between inflation and output stabilization induced by technological shocks in a DGE model with nominal and real rigidities that also integrates a rich menu of fiscal variables as well as a target on the debt to output ratio. The channels through which fiscal policy affects macroeconomic stability include supply-side effects of distortionary taxes, the procyclical behavior of public spending induced by fiscal rules and the conventional effect of automatic stabilizers operating through disposable (permanent) income. The paper investigates these channels and concludes that, contrary to what has been found in RBC models, distortionary taxes tend to reduce output volatility relative to lump-sum taxes when significant rigidities are present. We also study the stabilization effect of alternative (distortionary) tax structures and find that these are only relevant if substantial rigidities are present.     

Environmental taxation for environmental regulation and fiscal policy: An analysis of a Clinton-type BTU tax

This paper provides an empirical study of energy taxes for achieving environmental and fiscal policy objectives. Based on an energy tax structured like Clinton's 1993 BTU tax proposal, we demonstrate that the optimal tax will be higher the greater the environmental costs associated with energy consumption and the larger the economic distortions associated with alternative revenue-raising policies. Greater environmental damages and higher revenue-raising costs also have a fiscal policy implication; they shift the least-cost tax mix for raising additional revenue toward energy taxes and away from conventional tax alternatives.The authors wish to acknowledge the assistance of two anonymous referees, who provided very helpful feedback. We also wish to acknowledge outstanding research assistance from Tracy Terry of the School of Public and Environmental Affairs, Indiana University Bloomington. Of course, the results and conclusions of the paper are the authors' exclusively.     

Monetary policy and fiscal limits with no-default

This paper discusses monetary and fiscal policy interactions that stabilize government debt. Two distortions prevail in the model economy: income taxes and liquidity constraints. Possible obstructions to fiscal policy include a ceiling on the equilibrium debt-to-GDP ratio, zero or negative elasticity of tax revenues, and a political intolerance of raising tax rates. At the fiscal limit two mechanisms restore solvency: fiscal inflation, which reduces the real value of nominal debt, and open market operations, which diminish the size of government debt held by the private sector. Three regimes achieve this goal. In all regimes monetary policy is passive. In all regimes a muted tax response to government debt is consistent with equilibrium. The propensity of a fiscal authority to smooth output is found to determine what is an acceptable response (in the form of tax rate changes) to the level of government debt, while monetary policy determines the timing and magnitude of fiscal inflation. Impulse responses show that the inflation and tax hikes needed to offset a permanent shock to transfers are lowest under nominal interest rate pegs. In this regime, most of the reduction in the real value of government debt comes from open market purchases.     

Macroeconomic impacts of fiscal policy shocks in the UK: A DSGE analysis

This paper develops and estimates a new-Keynesian dynamic stochastic general equilibrium (DSGE) model for the analysis of fiscal policy in the UK. We find that government consumption and investment yield the highest GDP multipliers in the short-run, whereas capital income tax and public investment have dominating effect on GDP in the long-run. When nominal interest rate is at the zero lower bound, consumption taxes and public consumption and investment are found to be the most effective fiscal instruments throughout the analysed horizon, and capital and labour income taxes are established to be the least effective. The paper also shows that the effectiveness of fiscal policy decreases in a small open-economy scenario and that nominal rigidities improve effectiveness of public spending and consumption taxes, whereas decrease that of income taxes.     

Pension reserve fund,political budget cycles and fiscal illusion

We model political manipulations of pension reserve funds in a modified Shi and Svensson (2006) political budget cycle (PBC) model. Assuming that a share of voters suffers from fiscal illusion the incumbent can increase her re-election chances by prematurely spending parts of the reserve fund. We also obtain results that are counterintuitive, but only at first sight. First, it can be shown that the incumbent wants to reduce the manipulation when her ego rent increases. Second, the optimal magnitude of manipulation does not necessarily go up when the share of voters suffering from fiscal illusion rises.     

Does right or left matter? Cabinets, credibility and fiscal adjustments

This paper tests the widely held assumption that left-wing cabinets favor higher public spending and examines whether cabinet ideology affects the persistence of major fiscal adjustments. In a panel of large fiscal adjustments in OECD countries during the last 40 years, we find evidence that left-wing and right-wing cabinets are partisan: the left tends to reduce the deficit by raising tax revenues while the right relies mostly on spending cuts. Our testable hypothesis is that cabinets can signal commitment by undertaking fiscal adjustments in ways that are not favored by their constituencies. In other words, the left gains credibility when it cuts spending while the right becomes more credible when it increases tax revenues. Probit estimates of the determinants of persistence in fiscal adjustments confirm that spending cuts by the left and tax increases by the right are associated with persistent adjustments. The effect is significant for cuts in public spending, public consumption (wage or nonwage), increases in total revenues, direct taxes on businesses and other taxes. We test for the role of several other determinants of persistence, confirming that coalition and majority cabinets are associated with less persistence while periods of high or rising levels of indebtedness favor persistence. The estimates of the impact of ideology and other variables on GDP and its components show that it is the size of the spending cut rather than cabinet ideology that is most important.     

Exchange market reform,inflation, and fiscal deficits

This paper examines the effects of exchange market reform on inflation and quasifiscal deficits in developing countries. The first part presents the conceptual framework, which identifies a variety of implicit taxes and subsidies that must be taken into account (in addition to implicit taxes on exports, as emphasized by Pinto (1991)) in assessing the fiscal and inflationary effects of exchange market reform. A formula that attempts to capture explicitly these taxes and subsidies is derived. The second part applies the formula to six countries (Guyana, India, Jamaica, Kenya, Sierra Leone, and Sri Lanka). The results suggest that exchange market reform may lead to a significant reduction in reliance on the inflation tax.     

Government debt and optimal monetary and fiscal policy

How do different levels of government debt affect the optimal conduct of monetary and fiscal policies? And what do these optimal policies imply for the evolution of government debt over time? To provide an answer, this paper studies a standard monetary policy model with nominal rigidities and monopolistic competition and adds to it a fiscal authority that issues nominal non-state contingent debt, levies distortionary labor income taxes and determines the level of public goods provision. Higher government debt levels make it optimal to reduce public spending, so as to dampen the adverse incentive effects of distortionary taxes, but also strongly influence the optimal stabilization response following technology shocks. In particular, higher debt levels give rise to larger risks to the fiscal budget and to tax rates. This makes it optimal to reduce government debt over time. The optimal speed of debt reduction is missed when using first-order approximations to optimal policies, but is shown to be quantitatively significant in a second-order approximation, especially when technology movements are largely unpredictable in nature.     

Optimal climate and fiscal policy in an OLG economy

This paper develops a climate–economy model to study the joint design of optimal climate and fiscal policies in economies with overlapping generations (OLGs). I demonstrate how capital taxation, if optimal, drives a wedge between the market costs of carbon (the net present value of marginal damages using the market interest rate) and the Pigouvian tax (the net present value of marginal damages using the consumption discount rate of successive OLGs). In contrast to deterministic infinitely lived representative agent models, at the optimum, the capital income tax is positive, the carbon price equals the market costs of carbon but it falls short of the Pigouvian tax when (i) preferences are not separable over consumption and leisure; and (ii) labor income taxes cannot be age-dependent. I also show that restrictions on climate change policy provide a novel rationale for positive capital income taxes.     

Structural shifts in aid dependency and fiscal policy in developing countries

Foreign aid is a sizable source of government financing for several developing countries and its allocation matters for the conduct of fiscal policy. This article revisits the fiscal effects of shifts in aid dependency in 59 developing countries from 1960 to 2010. It identifies structural shifts in aid dependency and uses treatment effect methods to assess the fiscal effects of aid. It finds that shifts in aid dependency are frequent and have significant fiscal effects in developing countries. In addition to the traditional evidences of tax and investment displacement and ‘aid illusion,’ we show that upward shifts and downward shifts in aid dependency have asymmetric effects on fiscal accounts in developing countries. Large aid inflows undermine tax capacity and public investment while large reductions in aid inflows tend to keep recipients’ fiscal behaviour intact. Moreover, the tax displacement effect tends to be temporary while the impacts on expenditure items tend to last. Finally, we find that the undesirable fiscal effects of aid are more pronounced in countries with low governance score and low absorptive capacity.     

Prices vs. Quantities with fiscal cushioning

Enforcement of international environmental quantity regulations (e.g. tradable pollution permits) is often expected to be stricter than that of price regulations (e.g. emission taxes). While both instruments provide opportunities for misrepresenting actual pollution, enforcement of international price-based instruments is additionally hampered by potential fiscal cushioning, i.e. an adjustment of domestic fiscal policies offsetting the tax incentive to reduce emission reductions. The present paper extends the formal debate on Prices vs. Quantities by including the risk of fiscal cushioning. We find the level of the marginal benefit curve and the variance of costs become key elements for instrument choice and can render quantity regulations strictly preferable. Remarkably, in the latter case, the slopes of the marginal curves do not affect optimal instrument choice. Numerical calculations, using data taken from the international climate policy context, support the potential dominance of quantity regulations found in our formal analysis.     

Discretionary fiscal policy and economic activity in Greece

This paper investigates the effects of discretionary fiscal policy changes on economic activity and its subcomponents in Greece in the period 2000–2011. Changes in government spending and net taxes have Keynesian effects. An increase in government consumption has the most pronounced positive effects on output growth, private consumption and non-residential investment, while it reduces residential investment. Cuts in the public investment programme crowd in private investment, but are associated negatively with the net exports ratio. Both indirect and direct tax hikes lower private consumption, private investment and output growth. However, higher direct taxes by lowering disposable income they reduce import demand, thus, improving the trade balance.     

Which border taxes? Origin and destination regimes with fiscal competition in output and emission taxes

This paper posits a two-stage game in tax regime and tax rates to study the property of second-best emission and output taxes in a two-country world with an atmospheric externality. It shows that (i) either the destination–destination or the origin–origin tax regime may constitute the subgame perfect Nash equilibrium of this game; (ii) either regime may Pareto-dominate the other; (iii) it is possible to have a prisoner's dilemma game where the origin–origin regime Pareto-dominates but the choice of the destination regime is the dominant strategy for each country. Other results include (iv) under origin–origin regime: the output tax is used for fiscal competition; the emission tax is set at a rate equal to the (national) marginal social damage of emissions; and public goods are provided suboptimally. (v) Under destination–destination regime: the output tax is ineffective as an instrument for fiscal competition; the emission tax is used not only for combating pollution but also for tax competition; the tax is set at a rate below the (national) marginal social damage of emissions; emissions are pushed above their closed-economy level; the provision of public goods are optimal.     

Time‐consistent optimal fiscal policy*

This article studies the properties of optimal fiscal policy in a stochastic growth model when the government cannot commit itself beyond the next period's capital income tax rate. We find that the results contrast markedly with those under full commitment. First, capital income tax rates are very high (65% on average versus close to zero on average under full commitment). Second, labor income taxes are rather low on average (about 12% versus a value of around 31% under full commitment). Finally, labor income taxes are quite volatile, whereas under full commitment their standard deviation is essentially zero.     

Optimal fiscal and monetary policy under sticky prices

This paper studies optimal fiscal and monetary policy under sticky product prices. The theoretical framework is a stochastic production economy. The government finances an exogenous stream of purchases by levying distortionary income taxes, printing money, and issuing nominal non-state-contingent bonds. The main findings of the paper are: First, for a miniscule degree of price stickiness (i.e., many times below available empirical estimates) the optimal volatility of inflation is near zero. Second, small deviations from full price flexibility induce near random walk behavior in government debt and tax rates. Finally, price stickiness induces deviation from the Friedman rule.     

Competing in taxes and investment under fiscal equalization

The paper considers a model of federation with two heterogeneous regions that try to attract the capital by competing in capital income taxes and public investment that enhance the productivity of capital. Regions' choices determine allocation of capital across the regions and their revenues under a tax sharing scheme. This framework allows for the examination of different approaches to fiscal equalization schemes [Boadway, R., Flatters, F., 1982. Efficiency and equalization payments in a federal system of government: a synthesis and extension of recent results, Canadian Journal of Economics 15, 613-633; Weingast, B.R., 2006. Second Generation Fiscal Federalism: Implication for Decentralized Democratic Governance and Economic Development, Working Paper, Hoover Institution, Stanford University]. We show that tax competition distorts (downwards) public investments and that the equalization grants discourage public investments with a little effect on equilibrium taxes. However, the equalization schemes remain beneficial not only for the federation and, under a low degree of regional asymmetry, also for each region.