Prudent Budgetary Policywith Uncertain Revenues,

Investment Projects and Labour Market Reforms

For ‘Fiscal Policy and Labour Market Reforms’, 29/1/2008,

Swedish Fiscal Policy Council

Rick van der Ploeg

Oxford University

UvA and CEPR

OUTLINE 1. Introduction 2. Using public debt to smooth tax distortions 3. Dutch fiscal framework: cautious & trend-based 4A. Precautionary taxation and debt management with

uncertainty about future tax base (temporary & permanent shocks)

4B. Extensions: endogenous public spending, public investment and structural reforms

5A. Case for strong & pessimistic finance minister? Political economy of common pool problem.

5B. Warning: prudence may solicit electoral cycles 6. Guidelines for Conservative Budgetary Policy

2. USING DEBT TO SMOOTH TAX DISTORTIONS

The government maximizes social welfare, i.e., minimizes discounted value of tax distortions, subject to present-value budget government budget constraint.

Tax distortions are proportional to square of tax rate: big tax rates worse than small ones.

PV-GBC: present value of primary surpluses must exceed outstanding public debt. Or: PV of tax revenues must exceed commitments (i.e., PV of public spending plus debt).

Traditional Guidelines

Taxes must be used to finance permanent public spending and deficits to finance temporary spending (e.g., war, flood).

A temporary recession requires the government to run up government debt.

Anticipated hike in public spending (e.g., pensions) requires budget surplus to generate interest revenues to pay for hike.

A big level of public debt does not in itself justify measures to bring it down. Just levy taxes to finance the debt burden.

Guidelines ctd. However, if deficit is excessively large, budgetary

corrections must be taken. Does not make sense to rapidly bring taxes rates

for its own sake. With public spending endogenous as well, it is

optimal to have low spending if tax rates (i.e., the MCPF) are high.

Whether government uses budgetary slack to cut taxes or boost spending depends on political preferences.

Using Public Debt To Smooth Intertemporal Tax Distortions: SKIP

Minimize

2 2

1 1

1 1(1 )

2 2t tt t t

t t

r Y

subject to 1 1 1 1 1lim 0 s st s t s t s t s t

ss t

d y g d

yields1 1( ) ( ) and [ ( 1) ]/P P P P

t t t t t t t t t t td d g g y y g d y

with permanent levels of (detrended) public spending and national income given by

1 1( 1) and ( 1) .P t s P t st s t s

s t s t

g g y y

Extension: Public Investment

Maastricht criteria also does not allow for public sector assets and investment. So borrow for investment with market rate of return. Future returns pay for interest and principal.

Tax for finance of permanent losses on public investment projects.

In contrast, the Maastricht rules encouraged short-sighted privatization.

Comparison with Maastricht and SGP rules The 3% and 60% criteria for deficit-GDP and

debt-GDP ratios are ad hoc. If inflation is 2% and growth 3% per annum, criteria of 4% and 80% would have worked just as well (or say 1% and 20%). Each of them stabilize the debt-GDP ratio. Bringing down sharply the debt-GDP ratio also violates tax smoothing.

Maastricht targets are not corrected for cycle or for permanent and temporary shocks. And include interest on government debt.

Comparison with Maastricht .. Maastricht rules invite accounting gimmickry,

one-off operations, creative accounting if deficit is too large.

Rules also invite privatization for the wrong reasons and cut public investment more than unproductive public spending (easy targets).

E.g.: Net worth increased from 55% in 1970 to 74% in 1983 and then fell to 60% of GDP, but debt-GDP ratio fell from over 70% in 1970 to below 50% today.

Extension: Structural Reforms

Need to relax budgetary policy to muster political support for structural reforms that boost potential output, also to compensate losers and offset temporary unemployment.

Too tight SGP may have bias against reform. Recent extension of SGP allows for escape.

Theory suggest to immediately cut tax rates (and boost spending) in anticipation of fruits of reform, so need deficit for that as well.

3. DUTCH FISCAL POLICY FRAMEWORK 1994-2007 Cautious macroeconomic assumptions Net real expenditure ceilings for whole 4-year term

of government One decision-making moment each year Additional measures if signal value of deficit of 2 or

2.5% of GDP is exceeded Investment fund filled by 40% of gas revenues and

remainder for debt reduction Incentives and CBA to control, manage and

reorganize public expenditures

4. PRECAUTIONARY TAXATION AND PRUDENT BUDGETARY POLICY

Conservative/prudent finance minister deliberately under-estimates future growth in GDP by, say, 0.5%-point per annum, and thus under-estimates tax base and revenues.

Hence, finance minister deliberately sets tax rate too high and spending budgets too low. Over time, windfall revenues will appear which are used to gradually cut government debt. As debt service burden falls, tax rates can fall and spending levels can rise a bit.

Justification Depart from Tinbergen-Theil-Barro framework of

risk neutrality by allowing for risk aversion and prudence.

With linear model, normally distributed errors, quadratic preferences and constant absolute risk aversion, we can justify this theoretically where the parameter is the degree of pessimism or prudence of the policy maker.

Government effectively plays a min-max game against Mother Nature.

Precautionary Taxation:Use Min-Max Approach SKIP

Government plays game against nature and assumes the worst about nature:

1 2 1 2

2 2 2

, ,... , ,...1

1Min Max /

2tt t t

t

subject to government budget constraint and DGP for national income and tax base

211 , IN(0, ), 1t t t t ty y

1 0( 1), given t t t t td d g y d

This leads to budgeted under-estimation of national income and tax base:

2 2 tt

SKIP To avoid time inconsistency, assume:

2

0, .B Bs t s t

1 1

2

2 2

1( 1) 1

.

1

Pt t t

Bt t

d g y

Upon substitution into PV-GBC:

2

2 21 1 1

11 .P

t t t t t t tE d d g g y

Prudent minister of finance deliberately

underestimates future GDP and thus future tax base and revenues.

Hence, finance minister sets higher tax rate to be on safe side.

Over time windfall revenues will appear, which permit gradual reductions in public debt and thus in debt service and tax rate.

Higher persistence of stochastic shocks to national income imply bigger under-estimation of income and thus more precautionary taxation and bigger debt cuts.

Temporary Shocks2 21 ( ) 1 if 0.B B

t ty

2 21 1 1 1( ) ( 1) ( 1).P P

t t t t t t t t t tE d d g g y g g y

2112 2

( 1)( 1) if 0.

1

PPt t

t t t

d gd g

Precautionary taxation and precautionary fiscal surplus.

And temporary shocks are accommodated by higher deficit, not by higher tax rate.

Permanent Shocks

Tax rate21 1

1 12

2 2

( 1) ( 1)( 1) ( 1) if 0.

11

PPt t t

t t t t

d g yd g y

2

2 21 1( ) .

1P P

t t t t t t t tE d d g g g g

Anticipated budget deficit

Permanent shocks are accommodated by the tax rate, not by the deficit.Still precautionary taxation and surplus.

Endogenous Public Spending Precautionary under-spending. In contrast to traditional theory of tax smoothing,

the government builds up sufficient assets in the very long run to generate just enough interest revenue to afford the optimal level of public spending and ensure a zero tax rate.

Also the case in micro-founded optimal taxation literature with capital and with incomplete asset markets. Precautionary saving as substitute for initial tax on debt.

debt = 0

debt > 0

tax rate = 0

tax rate > 0

spending = 0

spending > 0

time

national income

Prudent reaction to permanent fall in the tax base

Prudent Approach to Public Investment Prudent approach for finance minister is to over-

estimate project costs and under-estimate future returns on the project.

Also political reasons to do this, since politicians and project developers tend to paint a too rosy picture to capture decision.

Hence, finance part by taxation and lower government consumption. If things turn out okay, gradually bring down debt and debt service. So can have modest tax cuts and rise in public consumption.

Structural Reforms

Not everybody agrees with leeway in budgetary policy to make possible reforms.

Brussels-Frankfurt consensus: tight implementation of SGP (fiscal consolidation) and structural reform go together.

There may be no alternative. Signal that government is tough and serious about reform.

Pork barrel and compensation funds need to be found by cutting elsewhere.

Prudent Approach Allow for uncertainty about short- and long-run effects of

structural reforms. Upswing may be due to cyclical factors (cf. Sweden).

Finance minister errs on safe side, so exaggerates short-run costs and plays down future benefits of reforms.

Conservative finance minister allocates fewer funds to soften short-run impact of reforms.

2005 revision of SGP: may deviate from medium-term budgetary objective and adjustment towards it if clear long-run cost-saving effects (including boost to growth).

5A. POLITICAL ECONOMY OF PRUDENCE & COMMON POOL Unfettered claims of spending ministers give rise to a

common pool problem if minister of finance is not strong enough.

Upward bias in public spending and public debt. Spending ministers spend too much and try to defer

taxation. Tax too little and too late. The minister of finance may then find it worthwhile to

offset the intertemporal biases with a prudent budgetary policy.

A strong finance minister is needed to cope with the intratemporal biases.

22

2

1

1

2E ( ) .ti ti

t

L g g

21 1 1 2 2 2 2

1 1

, IN(0, ),N N

i ii i

d g g

Use two-period setup with no 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.

Cooperative Outcome

First-best spending levels and tax rates are:

1 2 2 1 2 12 2

1 22 22 2 1

E , , 1,.., , 0,

E( , and) ,

C C C C C

i i i i

C C C C

Ng g g g g g i N d

N N

gN N

N

Smooth public spending and tax rates, hence no need for government debt.

Nash with Pre-Commitment

With pre-commitment, the non-cooperative outcome is given by:

1 2 1 2 1 1 12 2E E , 0, E( E( ,) )C C O O O C O

i i i i

C Og g g g g g d g

N NN

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.

Nash: without commitment

Without pre-commitment must impose subgame perfection and work backwards:

2

1 1

2

1

( ) ( )(1 ) 2 (1 ), 1,.., , =

( )( 2 1) ( )( 2 1)

( ) ( )(1 ) and 0.

( )( 2 1)

N Ni

N

N Ng g i N Ng

N N N N

N Nd Ng

N N

22

2 2

( 2 1) ( 1), 1,.., ,

( )( 2 1)

2and .

( )( 2 1)

Ni

N

N N Ng g i N

N N N

NgN N N

Comparing Outcomes

Feedback Nash outcome has both intertemporal and intratemporal distortions.

We can easily establish that:

1 2 1 1 1 2 2 2

1 2 1 2 1 2

N C2 1 1 2 1

>E , =E , E E ,

+E +E +E ,

, 1,.., ,

E( )> =E( ) and 0.

N N N O C C N Oi i i i i i i i

N N O O C Ci i i i i i

N C Ci i i

N C N

g g g g g g g g

g g g g g g

L L L i N

d

Prudent Minister of Finance

A pessimistic finance minister solves:

1 2

22

22 21 1 1 1 22 2

1 1

1 (1 )Min Max

2 ( ),

N N

i ji j

g g Ng gN

21 1 1 1 22 2

(1 ).

( )

BB

i ig g Ng NgN N

which gives rise to:

Prudence and Strong Finance Minister Mitigate the Common-Pool Problem

Ng1i Ng2i d1 1 2 Li

Cooperative 0.3333 0.3333 0 0.3333 0.3333 0 0.2

Pre-commitment Nash 0.4286 0.4286 0 0.4286 0.4286 0 0.2204

Commitment Nash 0.4418 0.4154 0.0462 0.3956 0.4615 0 0.2217

Prudent 2 = 0.1 0.4386 0.4186 0.0350 0.4036 0.4536 0.0807 0.2212

Prudent 2 = 0.2 0.4352 0.4219 0.0233 0.4119 0.4452 0.1648 0.2207

Prudent 2=0.35 0.4300 0.4272 0.0050 0.4250 0.4321 0.2975 0.2204

Prudent 2= 0.4 0.4282 0.4292 0.0014 0.4296 0.4275 0.3437 0.2204

Strong and prudent = 2.5, 2= 0.4 = 2.5, 2 = 0.8

0.35220.3358

0.31450.3308

0.04250.0057

0.30970.3302

0.35690.3365

0.24780.5283

0.20100.2000

Parameters: = g = 0.3, = 5 and N = 2.

Strong and pessimistic finance can attain the first best: see last row.

5B. WARNING: PRUDENCE MAY SOLICIT ELECTORAL BUDGET CYCLES

Ng1i Ng2i d1 1 2 Li

Open loop Nash 0.4286 0.4286 0 0.4286 0.4286 0.2204

Feedback Nash 0.4418 0.4154 0.0462 0.3956 0.4615 0.2217

Electoral = 0.1 0.4336 0.4235 0.0176 0.4160 0.4412 0.2206

Electoral = 0.5 0.4071 0.4500 0.0750 0.4821 0.3750 0.2239

Electoral =0.1666 0.4286 0.4286 0.0000 0.4286 0.4286 0.2204

Parameters: = g = 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 uponMoving 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.

6A. PRUDENT GUIDELINES Deliberately underestimate national income, tax

revenues and future returns on investment & overestimate investment costs.

Precautionary over-taxation and, if things turn out not too badly, slowly lower tax burden.

Precautionary under-spending and expect gradual rise in public spending.

Under-investment and hold back compensation for reforms.

Precautionary build up of assets to deal with outcomes worse than expected.

6B. POLITICAL ASPECTS

Give minister of finance and prime minister just as much voting rights as all the spending ministers to overcome the intratemporal spending bias of the common-pool problem

Use prudent budgetary policy to overcome the intertemporal spending bias of the common pool problem

But be careful: prudence may be abused by government in power for electoral budget cycles. Resulting volatility may harm social welfare.

New Dutch finance minister, Wouter Bos in 2007:

“Cautious economic assumptions do not serve stability, because it creates windfalls on papers .. and seduces politicians to play for Santa Claus during election years. They also stimulate procyclical policy: during an economic boom windfalls gains on the revenue side can be used for reducing taxes and in economic bad times there will be a rising deficit and a need for additional budget cuts. This is economically not very meaningful and only serves the political agenda of conservatives and liberals for a smaller government. .. My alternative is a fiscal policy based on realistic but not cautious estimate of economic growth.”

End of prudent budgetary policy in the Netherlands (move to an end-of-term fiscal surplus target).