Fiscal rules with discretion for an economic union

Abstract

The design of a fiscal rule involves a trade-off between committing governments to a fiscally responsible budget and giving governments the discretion to respond to shocks. What is the optimal degree of discretion for deficit-biased governments that are facing shocks to their fiscal needs? The tail of the distribution of shocks determines the optimal degree of discretion. If the tail is thin, an optimal rule features a cap on public spending enforced by off-equilibrium sanctions. If the tail is thick, an optimal rule grants more discretion than a cap could achieve at the cost of on-equilibrium sanctions. An optimal rule featuring on-equilibrium sanctions also features a threshold below which public spending is exempt from sanctions. The optimal exemption balances a loss of discipline on low levels of spending with an economy of sanctions on high levels of spending. These findings suggest avenues to reform the Stability and Growth Pact.