Fiscal policy targeting under imperfect information

Abstract

Systematic deficit biases and the sovereign debt crisis have increased interest in fiscal rules and institutions, in particular the setting of intermediate fiscal policy targets. Theoretical arguments point to targeting of the structural budget balance, but it is difficult in practice because this variable is riddled with measurement problems and noise. This paper first briefly documents the noise in measures of the structural budget balance, and then proceeds to analyse how this inherent information problem affects budget targeting. A strict targeting of the structural budget balance leads to excessive policy responses to transitory influences, and thus causes excessive policy activism in contrast to the underlying “smoothing” aim motivating fiscal policy targets. This points to a fundamental weakness of the recently implemented fiscal compact for EU countries requiring member states to target the structural budget balance on an annual basis.