Prudent Budgetary Policy. 60 th Anniversary VU Lustrum ‘Prudentia: Over Financieren en Begroten’ Rick van der Ploeg University of Oxford and UvA. OUTLINE. 1. Introduction 2. Using public debt to smooth tax distortions 3. Dutch fiscal framework: cautious & trend-based
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60th Anniversary VU Lustrum ‘Prudentia: Over Financieren en Begroten’
Rick van der Ploeg
University of Oxford and UvA
with permanent levels of (detrended) public spending and national income given by
Government plays game against nature and assumes the worst about nature:
subject to government budget constraint and DGP for national income and tax base
SKIP To avoid time inconsistency, assume:
This leads to budgeted under-estimation of national income and tax base:
Upon substitution into PV-GBC:
Precautionary taxation and precautionary fiscal surplus.
And temporary shocks are accommodated by higher deficit,
not by higher tax rate.
Anticipated budget deficit
Permanent shocks are accommodated by the tax rate,
not by the deficit.
Still precautionary taxation and surplus.
debt future GDP and thus future tax base and revenues. = 0
debt > 0
spending > 0
spending = 0
tax rate = 0
tax rate > 0
Prudent reaction to permanent fall in the tax base
Use two-period setup with no future GDP and thus future tax base and revenues.
unemployment or public capital
Each spending minister minimises the criterion
subject to the overall government budget constraint
and the conjectures about the behaviour of the
other spending ministers and the finance minister.
First-best spending levels and tax rates are:
Smooth public spending and tax rates, hence no need
for government debt.
With pre-commitment, the non-cooperative outcome is given by:
Spending and tax levels are higher than in cooperative outcome, but there is no tendency to postpone taxation and thus government debt is not used.
Only intratemporal, no intertemporal common-pool distortions.
Without pre-commitment must impose subgame perfection and work backwards:
which gives rise to:
Prudence and Strong Finance Minister Mitigate the Common-Pool Problem
= 0.3, = 5 and N = 2.
Strong and pessimistic finance can attain the first best: see last row.
5B. WARNING: PRUDENCE MAY SOLICIT Common-Pool Problem
ELECTORAL BUDGET CYCLES
= 0.3, = 5 and N = 2.
Give second-period welfare losses a weight greater than unity.
This gives rise to electoral cycle with high taxes and low spending upon
Moving into office and low taxes and high spending on election eve.
Build up assets to dish out favour on election eve.
Small values of overcome intertemporal distortions, but large values of
lead to excessive opportunistic political manipulation and bigger welfare losses.