Prudent Budgetary Policy
with 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





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
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


1
1 t 2
t 2
(1  r )  t Yt    t

t 1 2
t 1 2
Minimize
subject to
lim   s dt 1 s  0
s 
yields


  
s
s t
y
t 1 s t 1 s
 gt 1 s   dt 1
dt  dt 1  ( gt  gtP )   t ( yt  ytP ) and  t  [ gtP  (  1)dt 1 ]/ ytP
with permanent levels of (detrended) public spending and national income given by

g  (   1) 
P
t
s t
t  s 1

g s and y  (   1)  t  s 1 ys .
P
t
s t
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


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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:

Min
1 , 2 ,...

1
Max 
  t t2   t2 /  t2
1 , 2 ,...
t 1 2

subject to government budget constraint and DGP for national
income and tax base
dt   dt 1  gt   t   ( yt  1), given d0
yt  1     yt 1   t ,  t
IN(0,  t2 ),   1
SKIP To avoid time inconsistency, assume:
 t2   2  t
This leads to budgeted under-estimation of
national income and tax base:

B
s
  2 
 
  
 B
  t  0,

s  t.
Upon substitution into PV-GBC:
 t   tB
  1 
(   1) dt 1  gtP   
  yt 1  1






.
2
  
1   2 2 

  


 1  
P
2 2  
Et 1  dt  dt 1    gt  gt   
  yt 1  1    
 t.
  
  


2




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 underestimation of income and thus more
precautionary taxation and bigger debt
cuts.
Temporary Shocks
ytB  1  ( 2 ) tB  1 if  2  0.
Et 1 (dt  dt 1 )  gt  g  ( yt 1 1)     t  gt  g  ( yt 1 1).
P
t
2 2
P
t
 (  1)dt 1  gtP 
P
2
t  

(


1)
d

g
if

 0.

t 1
t
2 2
 1   

Precautionary taxation and precautionary fiscal surplus.
And temporary shocks are accommodated by higher deficit,
not by higher tax rate.
Permanent Shocks
Tax rate




P
(   1)dt 1  gt   ( yt 1  1) 
P
2
 t  

(


1)
d

g


(
y

1)
if

 0.
t

1
t
t

1
2


2 2 


1







  1 


Anticipated budget deficit
2
 
P
2 2
P
Et 1 (dt  dt 1 )  gt  gt    
  t  gt  gt .
  1 
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.
Prudent reaction to permanent fall in the tax base
debt  = 0
debt  > 0
spending  > 0
spending  = 0
tax rate  = 0
tax rate  > 0
national income
time
Prudent Approach to Public
Investment



Prudent approach for finance minister is to
over-estimate project costs and underestimate 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 longrun 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 costsaving 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.
Use two-period setup with no
unemployment or public capital
Each spending minister minimises the criterion
1 2
2
2 
Li  E    t   ( g  gti )  .
 2 t 1



subject to the overall government budget constraint
N
N
i 1
i 1
d1   g1i   1   2   2   g 2i ,
2
IN(0, 2 ),
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:
  
 N 
C
C
C
g E g 
g

g
,
g

g


,
i

1,..,
N
,
d
 0,
2i
1i
2
1

2 
2 
N 
N 
 
  
C
C
C
C 
 1  E( 2 )  
Ng , and  2  1  
 2 ,
2 
2 
N 
N 
C
1i
 
C
2i
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:
 

g1 i  E g 2 i  g1 i  E g 2 i
C
C
O
O
 

     N g  g,


d1  0,  1
O
C
 

 E( 2 )    E( 2 )  
 Ng ,
N
C
O
O
1
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:
N
1i
g
 ( N   ) 2  (   N )(1   ) 

 g,
(
N


)(
N

2


1)


N
1
and d


2  (1   )
i  1,.., N ,  1N = 
 Ng
(
N


)(
N

2


1)


 ( N   ) 2  (   N )(1   ) 

 Ng  0.
(
N


)(
N

2


1)


  ( N  2   1)  N ( N  1) 
  2 
g 2Ni  
g


 , i  1,.., N ,

(
N


)(
N

2


1)
N






and



2

 2N  
Ng



N
 ( N   )( N  2   1) 

  2 .

Comparing Outcomes


Feedback Nash outcome has both
intertemporal and intratemporal distortions.
We can easily establish that:
 
 
 
 
g1Ni >E g 2Ni , g1Ni  g1Oi  g1Ci =E g 2Ci , E g 2Ni  E g 2Oi ,
 
 
 
g1Ni +E g 2Ni  g1Oi +E g 2Oi  g1Ci +E g 2Ci ,
LiN  LCi  LCi , i  1,.., N ,
E( 2N )> 1N   1C =E( 2C ) and d1N  0.
Prudent Minister of Finance

A pessimistic finance minister solves:
2
2
N 
N









1

(1


)


2
2
2
Min Max   1    g  g1i   
Ng    g1 j    1   2     2  ,
2 


2  i 1 
 (N   )  
 j 1 
    
 
1
2
which gives rise to:
  2B 
  (1   ) 
B
  2     g  g1i   1  
Ng

Ng





1i
1
2 .
2
 (N   ) 
  N 


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
0.3522
0.3358
0.3145
0.3308
0.0425
0.0057
0.3097
0.3302
0.3569
0.3365
0.2478
0.5283
0.2010
0.2000
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 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.
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).