Marco Bassetto on the Quantitative Evaluation of Fiscal Policy Rules
Marco Bassetto is a Senior Economist in the Economic Research Department at the Federal Reserve Bank of Chicago. He is interested in political-economy models of fiscal policy and in applications of game theory to the analysis of macroeconomic policy more in general. This piece reflects the personal views of the author and not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Bassetto’s RePEc/IDEAS entry.
In 2009, the federal government is poised to run the biggest peacetime deficit in the history of the United States (both in absolute value and as a fraction of gross domestic product, or GDP). Current projections suggest that large deficits will persist in future years, considerably raising the debt/GDP ratio and putting additional strains on future public finances, which will soon also be challenged by the retirement of the baby boomers.These developments are likely to rekindle debate about the desirability of imposing restrictions on government indebtedness. Constraints on deficit financing are the norm for state and local governments in the United States, and they are part of the European Stability and Growth Pact (SGP) to which eurozone countries have committed.
There is a large political-economy literature on government deficits and debt. On the theoretical side, most papers derive qualitative predictions from stylized models. On the empirical side, many papers have studied the consequences of different fiscal constraints on spending and debt (see, e.g., Poterba, 1994 and 1995, Bohn and Inman, 1996); these papers provide quantitative answers, but they do not contain a model that can be used for welfare considerations, or to extrapolate to fiscal institutions that have not been used in the past.
Few papers have attempted to bridge the gap, developing quantitative theoretical models that can be used to study the welfare properties of different fiscal restrictions. As an example, Krusell and Ríos-Rull (1999) have studied the dynamics of government redistribution under a balanced budget, as a function of the frequency with which government decisions are taken.
In this piece, I review some recent quantitative contributions that deal with fiscal deficits and debt, and I discuss open questions that warrant future consideration.
In the first set of papers, a balanced-budget restriction (BBR) is necessarily desirable, and the research question is whether public investment should be subject to the BBR in the same way as ordinary government expenses. The second set of papers abstracts from government investment, but introduces a cost of enacting a BBR, through the inability to smooth tax rates in response to shocks. It then becomes possible to discuss under what conditions a BBR actually improves welfare.
2. Does public investment deserve special treatment?
One of the main complaints about the original form of the European SGP concerned the lack of special provisions for public investment (see, e.g., Monti, 2005). Its reform in 2005 heeded these criticisms, and now “policies to foster research and development and innovation” are taken into account in evaluating whether a deficit is truly excessive (European Council on the Stability and Growth Pact, 2005, article 1).Similarly, all U.S. states can borrow to pay for long-term capital projects. They follow what is known in public finance as the “golden rule,” whereby a jurisdiction should balance its operating budget, but should be able to borrow to pay for capital improvements. This rule has a long tradition both in theory and actual policy, and is mostly justified on the grounds of “fairness”: The operating budget is assumed to benefit current residents, who should thus bear its cost, while public improvements offer long-run benefits to future generations, which implies that it is fair to also ask them to share the burden by using debt financing.
How important was the 2005 reform of the SGP for restoring appropriate incentives to invest in public infrastructure? If a balanced-budget amendment were included in the U.S. Constitution, would public capital deserve special treatment? What other features of the environment are relevant in assessing the quantitative impact of different provisions? We look for the answers to these questions in a series of recent papers.
In Bassetto with Sargent (2006), we introduce the framework of analysis and apply it to the Unites States. In this research, we consider an economy populated by overlapping-generations of potentially mobile households, in which government spending is chosen period by period by current residents. In their decisions, voters only take into account their own present and future costs and benefits, while they neglect those that will accrue to other future residents (new people coming of age or new immigrants).
The government produces two types of public goods: One is durable, while the other is not. The environment is such that a BBR necessarily yields a Pareto-efficient choice for nondurable public goods: all households alive are assumed to benefit in the same way, and to also pay taxes in the same amount. A BBR forces current households to pay exactly for the services they get from the government, and yields correct incentives. The same does not happen for public investment, since current investment will have long-lasting benefits.
We analyze a constitutional restriction on government indebtedness that features two key parameters:
a. The fraction of government investment that can be excluded from the deficit count (e.g., 100% according to the golden rule) and
b. The maturity structure of debt, which measures how fast newly incurred debt has to be repaid.
Two relevant conflicts emerge in the determination of public investment: the first among current voters, who are heterogeneous by age and thus face different mortality and mobility profiles, and the second between current voters and future residents. With a growing population, the second effect always dominates under a pure BBR, leading to underinvestment: the current voters fully take into account the immediate cost, but they only partially internalize future benefits. Under further mild restrictions on the demographic structure and/or the maturity of debt, we obtain the intuitive result that allowing some issuance of debt alleviates the underinvestment.
In our quantitative calibration, we assume that the government is allowed to issue long-term debt that has to be repaid gradually over time through a sinking fund. This is a common practice among U.S. states. For this case, we establish the following results.
a. The golden rule, with 100% deficit financing of public capital, tends to perform very well. The precise amount of deficit financing that exactly yields an efficient outcome is not affected much by the demographic details.
b. When the constitutional restriction is far away from the optimum, demographics are important for the magnitude of the resulting distortions. This is not surprising, since demographics are what drives the economy away from Ricardian equivalence in our context.
c. When the borrowing limit treats public capital and nondurable public consumption in the same way, we find much bigger distortions at the state level than at the federal level. At the state level, people discount future costs and benefits because of mobility more than mortality: at most ages, the hazard of moving out of state is much higher than the hazard of death. By contrast, the hazard of moving out of the United States is negligible.
The quantitative results thus suggest that the current pattern of U.S. institutional restrictions is well matched to its theoretical benefits: the golden rule is practiced by the states, where benefits are likely to be large, but not at the federal level, where benefits would not be as prominent.
In Bassetto and Lepetyuk (2007), we apply the same model to European data. As expected, the costs of not including an investment exemption in the SGP turn out to be modest: European countries are about as far away from Ricardian equivalence as the U.S. federal government, with a somewhat higher hazard of emigration offsetting lower population growth.
More surprisingly, we find that the golden rule performs rather poorly in the context of the SGP, generating distortions from overinvestment that are about as big as those for underinvestment in the original version of the SGP, which treated operating and capital expenses symmetrically. This is because the SGP only counts interest payments against a country’s deficit allowance, allowing indefinite rollover of debt principal. Thus, under the golden rule the additional taxes needed to pay for public investment would be shifted into the future much more than the benefits from the investment. Two possible solutions to this problem are as follows:
a. excluding less than 100% of investment from the deficit count (in our numerical results, about 50% turns out to be appropriate); and
b. excluding net, rather than gross,investment from the deficit count. By including depreciation in the deficit count, this strategy is equivalent to forcing a gradual repayment of the debt that is issued to finance public investment. The drawback of this strategy is that depreciation is difficult to measure, opening a new margin to skirt the rules.
In ongoing work (Bassetto, 2009), I extend the analysis to account for the possibility of endogenous mobility, as well as different tax bases. This extension of the research is particularly important to understand which rules are best suited for local communities, where the household location decision is much more likely to be affected by local amenities and taxes.
Starting from Tiebout (1956), there is a large literature in local public finance that considers how endogenous location affects voters’ incentives. One of the central themes in this literature is capitalization: local amenities and debt are likely to be reflected in the property prices. The theoretical literature (see, e.g., the survey by Mieszkowski and Zodrow, 1989) has analyzed in detail the environments that are more or less conducive to capitalization. Most of these papers consider static environments, with a few considering overlapping-generations of households living for two periods; thus they are difficult to use for quantitative policy analysis. There is also a vast empirical literature that has tried to estimate the magnitude of capitalization.
I develop a dynamic model with long-lived agents, in which the parameters of the model can be more easily related to empirical counterparts, to deliver quantitative predictions about the effects of different policy rules on the efficiency of government spending.
When the tax base is income, endogenous mobility creates two opposing forces on the voters’ incentive to provide public capital. First, a congestion externality is exacerbated: when additional public capital makes a location more attractive, more people move to that location, free-riding on the original investment and diluting its benefits for the original residents. Second, capitalization mitigates the externality: the increased demand for living in the location raises property prices, which benefits the original residents (assumed to own their house). Thus, it is important whether equilibrium adjustments mainly occur through quantity (population size) or through price.
Early quantitative results hint that the price adjustment will be insufficient to provide appropriate incentives for local public investment. An explicit rule that favors capital investment is thus called for. Alternatively, zoning restrictions are needed to drastically limit adjustment in population size.
3. Should we impose a BBR on the federal government?
Answering this question is one of the themes in recent work by Battaglini and Coate (2008a, 2008b) and Azzimonti, Battaglini, and Coate (2008). In their work, in each period the public sector can use its resources in two different ways: by providing public goods or by redistributing resources toward favored groups (“pork-barrel spending”). Public revenues come from a distortionary tax on labor, and the government has access to risk-free borrowing and lending, but cannot issue state-contingent debt. In each period, each group (“district”) has one representative in the policy-making body (“Congress”), and a random coalition forms and makes a decision.In this environment, debt is potentially beneficial for tax-smoothing considerations, such as in Barro (1979) and Aiyagari et al. (2002). However, access to debt is also a potential source of inefficiency, since the partisan nature of some policies introduces a deficit bias akin to what Alesina and Tabellini (1990) and Tabellini and Alesina (1990) describe. Specifically, in each period, the coalition in power has the opportunity to appropriate government funds and redistribute them to its own constituents. This is ex ante undesirable, since it involves raising revenues with distortionary taxes and rebating the proceeds to (a random group of) taxpayers. However, ex post, the transfers may be beneficial to the group in power at the expense of the others. Running deficits constrains future coalitions, which may redistribute government funds in ways that the current coalition finds undesirable.
Battaglini and Coate (2008a, 2008b) prove that the economy will necessarily alternate between two regimes:
a. “Responsible policy-making,” when the marginal distortions from taxation are sufficiently high as to discourage diversion of public funds for redistributive purposes and
b. “Business as usual,” when public resources are less scarce and the coalition in power engages in such targeted spending.
Responsible policy-making will prevail when the economy inherits a high level of public debt, or when it faces an adverse shock such as a high need for the general public good (e.g., during a war). When the adverse shock ends, the debt level gradually drifts lower, until it reaches a level at which business as usual restarts.
An important observation is that a BBR is a cure for one of the symptoms of inefficiency, but not for its source. While a deficit bias obviously disappears under a BBR, pork-barrel spending does not. In a calibrated example, Azzimonti, Battaglini, and Coate (2008) show that the prevalence of pork-barrel spending actually increases under a BBR, since the governing coalitions are no longer subject to the fiscal discipline imposed by servicing large amounts of debt. This insight potentially applies to many other environments, and serves as a warning that curing deficits simply by banning them may cause undesirable consequences unless we have a clear understanding of the political frictions that generate Pareto-dominated outcomes.
In ongoing work, Azzimonti, Battaglini, and Coate (2008) evaluate quantitatively the consequences of a balanced-budget amendment to the U.S. constitution. Their preliminary results show that the welfare consequences depend on the initial level of debt. When the government is not initially subject to a BBR and debt is at any of the values in the support of the associated ergodic distribution, introducing a BBR would never be desirable.
Azzimonti, Battaglini and Coate’s calibration struggles to match the pattern of peacetime deficits, since the shock-absorbing role of government debt is minor in response to typical business-cycle shocks. This may be of concern because the cyclical behavior of spending is used to identify the magnitude of political distortions. Nonetheless, the match to the actual variability of spending and debt is quite good when the possibility of large shocks such as World War II is introduced, and their work represents an important step in developing a dynamic quantitative model of the costs of partisan policymaking.
4. Where should we go next?
The papers described in the previous sections are but one step in bringing quantitative economic modeling to the optimal design of fiscal institutions. Future work will have to develop in three dimensions:
The previous analysis relies on specific political-economic frictions. To what extent do the implications generalize to other settings? As an example, let me briefly speculate on the robustness of the results about the golden rule.
It is straightforward to see that the rule would be much more beneficial if we assumed that operating budgets are subject to a deficit bias arising from partisan policymaking, while public investment is purely for the common good, as in Peletier, Dur, and Swank (1999), Azzimonti (2004), or Battaglini and Coate (2007). However, this assumption is at odds with the observation that “pork projects” are often capital items (e.g., the now infamous “bridge to nowhere”).
Consider instead the following scenario, vaguely inspired by work of Rogoff and Sibert (1988), Rogoff (1990), and Besley and Smart (2007). Suppose that it takes time for voters to correctly assess the benefits of a long-term project (e.g., investment in renewable energy resources). Then, in the short run, it is difficult for the voters to distinguish the farsighted politicians, who are able to discern good projects, from the incompetent ones, who may pick projects more or less at random. This difficulty may bias policymaking to short-term projects, for which competence may be easier to signal to voters. Is this an important quantitative force? Only by developing models that are more detailed will we be able to gain confidence in the robustness of the institutional recommendations.
b. Analysis of other fiscal institutions
In this discussion, I have only addressed two specific questions. In practice, there are of course countless other dimensions of fiscal institutions worth considering. Taking again inspiration from current events, the stimulus package signed into law by President Obama on February 17 contains substantial transfers from the federal government to state governments. Moreover, federal matching is a standard feature for some expense items (such as interstate highways) but not in others (education). How large should a federal match be, and in what circumstances should it be granted? Are externalities from public goods quantitatively more important for this question, or is it more important to pay attention to insurance and discipline (see, e.g., Persson and Tabellini, 1996a and 1996b, or Sanguinetti and Tommasi, 2004)?
These questions are important not just for the United States, since transfers from the central government to regional/provincial governments are or have been prominent in a number of countries (e.g., Argentina, Brazil, or Italy).
c. Tax base
Should we rely more or less on property taxes, rather than income taxes, to finance government expenditures? Two provocative papers by Rangel (2005) and Conley and Rangel (2001) argue that land taxes (based on pure acreage, not value) would be very beneficial for intertemporal incentives. As we discuss in Bassetto (2009), the drawback of pure land taxes is that they would be unable to generate substantial revenues without dragging the value of the marginal land to zero, at which point the scheme unravels. Does this imply that we should move towards income or sales taxes? Or should we instead consider property taxes, which may have beneficial capitalization effects but distort capital accumulation?
d. Intergenerational accounting
In the works cited previously, what represents a deficit is clearly defined, and government debt captures well the intertemporal effects of fiscal policy. Yet Auerbach and Kotlikoff (along with various coauthors) have forcefully argued for intergenerational accounting as a more comprehensive and appropriate measure (see, e.g., Auerbach, Gokhale, and Kotlikoff, 1991 and 1994, and Kotlikoff, 1992).
In the context of distortionary taxation, a similar point is made formally in Bassetto and Kocherlakota (2004): When the government has the power to tax (or subsidize) past income, the same allocation can be supported by arbitrary paths for government debt (for an application to Social Security, see Grochulski and Kocherlakota, 2007). This is particularly an issue in models of “new dynamic public finance,” where the fiscal distortions arise purely out of asymmetric information between the private sector and the fiscal authority. In these papers, the ability to tax past income is always present, and the deficit path may be correspondingly indeterminate.
Several papers have looked at the political-economy of intergenerational accounting, particularly from the perspective of social security (see, e.g., Cooley and Soares, 1996, Galasso, 1999, Song, Storesletten, and Zilibotti, 2007, and Bassetto, 2008). The introduction of a balanced-budget restriction would most likely interact with the considerations raised in these papers.
e. Timing of institutional reforms
Policy choices are endogenous in the work described previously, but institutional constraints are taken as given, and the goal of the research is to assess the welfare properties of imposing alternative restrictions on fiscal policy. A separate but important issue is when an institutional reform takes place, and how. In the case of U.S. states, the introduction of balanced-budget requirements dates back to the aftermath of the state defaults of the 1840s (see, e.g., Secrist, 1914). These constitutional reforms took place at a time when access to borrowing for states was severely disrupted; indeed, a renewed commitment to fiscal responsibility could be viewed as a way of restoring access to credit markets. This is but one example of a general pattern, whereby major fiscal reforms often follow a public finance crisis (for some other examples, see Sargent, 1983a and 1983b). The largely ineffective Gramm-Rudman-Hollings Act of 1985 could also be seen in this light – it was a preventative measure that was enacted out of concern for the consequences of the then-unprecedented deficits of the Reagan era.
While these considerations warrant a more systematic analysis, they suggest to me that now may be the perfect time for economists to engage in a debate over the fiscal institutions that will serve the United States for the next generation and beyond.
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