Consistent flexibility: Enforcement of deficit rules through political incentives

Abstract

We study the optimal design of a deficit rule in a model in which the government is present-biased, shocks to tax revenues make rule compliance stochastic, and a rule violation reduces the payoff from holding office. We show that: (i) the benchmark policy of the social planner can be always implemented via an optimal nonlinear deficit rule and under certain conditions even under a linear rule; (ii) the optimal rule prescribes a zero structural deficit but only partially accounts for shocks; and (iii) a government with a stronger ex-ante deficit bias should be granted a higher degree of flexibility.