The hidden compliance zone of fiscal rules

ABSTRACT

This paper studies fiscal rule compliance under uncertainty and irreversibility. I show that a broad class of fiscal rule designs contain a state space in which the government optimally complies with the rule in place, a compliance zone. Outside the compliance zone, the government exerts control on the path committed by the rule. I also show that the size of the rule’s compliance zone depends on two elements: first, how the rule copes with the uncertainty regarding the macro variable that underlies it; and second, how the fiscal spending path committed by the rule accommodates the demand for public goods.

KEYWORDS:

• Fiscal rules
• compliance
• uncertainty
• irreversibility

JEL CLASSIFICATION:

• E60
• E61
• E62

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary material

Supplemental data for this article can be accessed online at https://doi.org/10.1080/13504851.2022.2078771.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

¹ Universidad Adolfo Ibáñez, School of Business; email address: [email protected].

For instance, a fiscal rule may be enshrined in different levels of legislation, monitored by independent bodies, enforced by different monitoring mechanism, and so on.

² The divergence in the conclusion regarding which rule exhibits higher compliance might be explained by differences in the compliance measure considered across studies.

³ State-provided goods encompass pure public goods (non-excludable and non-rivalrous), pure private goods (excludable and rivalrous), and hybrids of these categories. A strand of the literature uses happiness surveys to value pure public goods, such us terrorism protection (Frey, Luechinger, and Stutzer 2009), climate (Rehdanz and Maddison 2005), and air quality (Luechinger 2009; Welsch 2009), and find positive effects of the provision of these goods on well-being. In the case of private goods, the equilibrium market price shows the willingness to pay by the marginal agent.

⁴ Hereafter, I will refer to state-provided goods simply as public goods.

⁵ Governments could adopt explicitly reversible discretionary policies, as seen in some countries with the measures adopted during the COVID-19 pandemic. However, a partial irreversibility of fiscal spending in some budget items related to social demands is sufficient to generate the main results of this paper. The evidence described in this paragraph supports that premise.

⁶ I define an out-of-rule fiscal expansion as any increase of fiscal spending beyond what is mandated by the rule in place.

⁷ These designs embody characteristics of a wide variety of fiscal rule arrangements, as I will discuss later.

⁸ Therefore, the notion of uncertainty in this paper follows Dixit and Pindyck (1994). These authors analyse investment decisions under uncertainty and use continuous-time stochastic processes (Ito processes) to represent the dynamics of variables that evolve stochastically over time. Furthermore, in Dixit and Pindyck’s analysis, the diffusion parameter of the stochastic process is used to measure the amount of uncertainty over future values of the corresponding variable. Note that equations (2)(2) $dZ(t)={\mu }_{Z}Z(t)dt+{\sigma }_{Z}Z(t)d{W}_Z(t),$(2) and (3(3) $dR(t)={\mu }_{R}R(t)dt+{\sigma }_{R}R(t)d{W}_R(t)$(3) ) follow the same approach to model uncertainty regarding the demand index and government revenues, respectively. Furthermore, the specific modelling assumption for the processes $\{Z(t)\}$ and $\{R(t)\}$ is a reasonable and realistic representation of uncertainty, as highlighted by Bertola and Caballero (1994). This formulation also facilitates the derivation of a closed-form solution of the model.

⁹ The cost of non-compliance may be determined by the institutional arrangement under which a rule operates. Then, the homogeneity (across rules) of the cost of non-compliance allows me to focus the analysis, exclusively, on the relation between the rule’s design and the rule’s compliance zone.

¹⁰ This is a direct consequence of Assumption A1, discussed in Appendix A.

¹¹ Recall that Proposition 2 states that a higher variance of the motion followed by the ratio between the public good provided by the government and the public good demanded by the population, that is a higher ${\tilde{\sigma }}_f$, implies a larger compliance zone, that is, a lower ${\varphi }_f$.

¹² I thank an anonymous referee for proposing these simulations.

¹³ Simulations with data from other countries can be carried out in a similar way.

¹⁴ Then, I assume that expected government revenue growth mirrors trend GDP growth, and the volatility in revenues is triggered by volatility in GDP. These relations are observed in the data.

¹⁵ These parameters are not trivial to choose; however, results are not very sensitive to changes in these parameters. Results using other values of $\alpha$ and $c$ are available upon request.

¹⁶ Results in this table are presented for the case ${\rho }_{RZ}=0$. Results for other cases are available upon request.