Welfare-maximizing Policy Research Articles

Towards data-driven project design: Providing optimal treatment rules for development projects

It is increasingly commonplace among development practitioners to employ impact evaluations to measure the performance and effectiveness of their activities and investments. However, there remains a substantial gap between the evidence generated by these assessments and its use for prospective planning and design of future development projects. Specifically, the retrospective data generated in counterfactual-based evaluations on what worked, how, and for whom, is not routinely or easily applied by policymakers for decision-making after an evaluation's closure. We address this gap through the development of an optimal policy learning (OPL) tool for rural development projects that leverages observational data to drive data-driven project design through identification of welfare-maximizing targeting and selection rules that can maximize project impacts. In so doing, we solve the policymaker's policy assignment problem, i.e. deciding who to treat and where. Further, we define distinct roles for the policymaker and the analyst in which the latter is tasked with generating a menu of potential selection rules while the former weighs each rule's costs and benefits against their objective function, addressing the practical constraints poised by optimal policy learning's use for project design. To illustrate the utility of our approach we apply OPL to two projects funded and evaluated by the International Fund for Agricultural Development (IFAD). We show that OPL and this division of labor not only identifies the welfare-maximizing policy assignment but also allows policymakers to gain deeper insights into the trade-offs, costs, and benefits of different objectives, policies, and demands facilitating more informed decision-making and more effective policies and development interventions.

Presidents, Fed chairs, and the deviations from the Taylor rule

AbstractThis paper examines whether changes in US presidential administration and central bank turnover during the period 1976–2016 caused regime shifts in Taylor rule deviations. Using a dynamic stochastic general equilibrium model to construct the welfare-maximizing policy rule and deviations from the optimal rule, we find evidence that politics indeed play a key role in explaining these deviations. In addition to politics, unemployment rates and the interest rate spread significantly account for regime shifts in Taylor rule deviations.

Unemployment risks and intra-household insurance

To study the constrained efficient public insurance provision against unemployment risks, we build a directed search model with households where a spouse's ability to provide consumption insurance determines the risks job-seekers take on. The planner's transfers to the unemployed fall with the spouse's income because of concave preferences with limited complementarity between consumption and the spouse's labor. Due to the absence of such a transfers scheme in the laissez-faire equilibrium, too many too-low-wage jobs are created as jobless workers seek insurance in the labor market. Social welfare-maximizing policies with simple tax schemes exhibit unemployment benefits falling with spouse's income, and nearly fill up the welfare gap.

On Why Affirmative Action May Never End and Why it Should

Successive welfare-maximizing governments must decide whether to implement an affirmative action policy. This affirmative action policy is purported to improve the performance distribution of a targeted group (minority or otherwise), although this improvement becomes trivial when the policy is implemented over a long period of time. Employers pay workers according to their expected productivity, but without (perfectly) observing whether they benefited from affirmative action or not. This has a depressing effect on the wages of non-beneficiaries (whether or not they belong to the targeted group), leading in turn to a feeling of injustice. We find that governments perpetually choose to implement an affirmative action policy, even though the overall feeling of injustice is worse than the purported beneficial effect on the performance of the targeted group (which becomes marginal over time). The explanation we propose is based on a novel moral hazard argument: Each government's actual policy decision is not (perfectly) observed by market participants and thus has no direct effect on wages. Governments therefore do not internalize the depressing effect of an affirmative action policy on wages when choosing to implement it. This outcome is in sharp contrast with a first-best, welfare-maximizing policy plan, in which governments choose to end affirmative action after a certain number of periods, when the purported improvement in the performance distribution of the targeted group becomes small enough.

Optimal Industrial Policies in a Two-Sector-R&D Economy

Abstract This study characterizes welfare-enhancing industrial policies in a two-sector-R&D economy that incorporates both vertical and horizontal innovation. It elaborates on current welfare analyses of two-sector-R&D economies along two lines. First, it explores the welfare properties of non-drastic innovations whereas current analyses are confined to drastic innovations. It is shown that while the endogenously chosen size of drastic innovations is insufficient compared to social optimum, the size of non-drastic innovations may be excessive compared with the welfare maximizing one. Second, it explores welfare-enhancing policies designed to restrict innovators’ market power, whereas current policy analyses focus on R&D and market-entry subsidies. The welfare-maximizing policies presented here combine proper limitations on innovators’ market power along with a corresponding production tax (or subsidy). The limitations over innovators’ market power are aimed to support the optimal innovation size, and the corresponding production tax is set to support the optimal product variety span.

Investment timing and capacity decisions with time-to-build in a duopoly market

In this study, we investigate optimal investment timing and capacity decisions in the presence of time-to-build and competition. Due to uncertain time-to-build, a leader, who invests first, may have its product enter the market after a follower’s. We show that a dominated firm with the longer time-to-build can become a leader by making the investment earlier than a dominant firm with shorter investment lags. The leader’s capacity choice increases with the dominated firm’s time-to-build, even if the dominated entity is the leader. This finding is consistent with the observation in the electric vehicles market in which a relatively new firm with little experience of mass production makes aggressive investment early on, while the biggest carmakers capable of mass production are timing their investment. With a welfare-maximizing policy, however, the dominant firm with the shorter time-to-build always becomes the leader. There is a significant loss of social welfare with the dominated firm being the leader, and the loss increases with the asymmetry of time-to-build.

Optimal capital account liberalization in China

China maintains tight controls over its capital account. Its current policy regime also features financial repression, under which banks are required to extend funds to state-owned enterprises (SOEs) at favorable terms, despite their lower average productivity than private firms. We incorporate these features into a general equilibrium model. Our model illustrates a tradeoff between aggregate productivity and inter-temporal allocative efficiency from capital account liberalization under financial repression. As a result, along a transition path with a declining SOE share, welfare-maximizing policy calls for rapid removal of financial repression, but gradual liberalization of the capital account.

Optimal Capital Account Liberalization in China

China maintains tight controls over its capital account. Its current policy regime also features financial repression, under which banks are required to extend funds to state-owned enterprises (SOEs) at favorable terms, despite their lower productivity than private firms on average. We incorporate these features into a general equilibrium model. Our model illustrates a tradeoff between aggregate productivity and inter-temporal allocative efficiency from capital account liberalization under financial repression. As a result, along a transition path with a declining SOE share, welfare-maximizing policy calls for rapid removal of financial repression, but gradual liberalization of the capital account.

Government Debt Limits and Stabilization Policy

We evaluate alternative public debt management policies in light of constraints imposed by the effective lower bound on interest rates. Replacing the current limit on gross debt issued by the fiscal authority with a limit on consolidated debt of the government can ensure that output always reaches its potential, but it may permit excess government spending when the economy is away from the effective lower bound. The welfare-maximizing policy sets the gross debt limit to the level implied by Samuelson (1954), while the central bank finances government spending with money when the economy is at the effective lower bound.

Investment Timing and Capacity Decisions with Time-to-Build in a Duopoly Market

We investigate firms' optimal investment timing and capacity decisions in the presence of time-to-build and competition. Due to the uncertainty in time-to-build, the product of the leader who makes the first investment might enter the market later than that of the follower. We show that a firm dominated by investment lags can become a leader and that the leader's optimal capacity increases in the size of the dominated firm's lags, even when the dominated firm becomes the leader. This result is consistent with the electric vehicles market, in which a relatively new firm lacking experience in mass production makes an aggressive investment, while the biggest car makers capable of mass production with shorter lags are timing their investment. With a welfare-maximizing policy, however, the dominant firm always becomes the leader. Compared to investments according to the welfare-maximizing policy, the leader and follower's investment choices in the market are inefficiently late and early, respectively. The welfare-maximizing capacities of both the leader and the follower are much higher than those determined in the market, but the difference is more pronounced in the leader's capacity. There is a significant loss of social welfare resulting from the dominated firm becoming the leader, and the loss increases as the dominated firm's time-to-build increases.

Optimal Policies in the Dasgupta—Heal—Solow—Stiglitz Model under Nonconstant Returns to Scale

The paper offers a complete mathematically rigorous analysis of the welfare-maximizing capital investment and resource depletion policies in the Dasgupta—Heal—Solow—Stiglitz model with capital depreciation and any returns to scale. We establish a general existence result and show that an optimal admissible policy may not exist if the output elasticity of the resource equals one. We characterize the optimal policies by applying an appropriate version of the Pontryagin maximum principle for infinite-horizon optimal control problems. We also discuss general methodological pitfalls arising in infinite-horizon optimal control problems for economic growth models, which are not paid due attention in the economic literature so that the results presented there often seem not to be rigorously justified. We finish the paper with an economic interpretation and a discussion of the welfare-maximizing policies.

Fiscal policy under a minimum-time objective

In an endogenous growth model, we characterize the fiscal policy driven by a minimum-time objective of economic development. We find that in equilibrium government should levy the highest possible consumption taxes, reduce public expenditures to the lowest possible level, and keep labor income tax rate and capital income tax rate satisfy a substitution relationship at the balanced budget constraint. We also identify the condition under which income tax rate should be set to zero. We further find that the equilibrium fiscal policy is equivalent to the growth-maximizing fiscal policy, whereas it generally deviates from the welfare-maximizing fiscal policy. We hence identify a circumstance where setting the policy goal of reaching an economic-performance target as soon as possible cannot be justified in the sense of maximizing the welfare of households.

Efficiency, Welfare, and Political Competition *

Abstract We study political competition in an environment in which voters have private information about their preferences. Our framework covers models of income taxation, public-goods provision, or publicly provided private goods. Politicians are vote-share maximizers. They can propose any policy that is resource-feasible and incentive-compatible. They can also offer special favors to subsets of the electorate. We prove two main results. First, the unique symmetric equilibrium is such that policies are surplus-maximizing and hence first-best Pareto-efficient. Second, there is a surplus-maximizing policy that wins a majority against any welfare-maximizing policy. Thus, in our model, policies that trade off equity and efficiency considerations are politically infeasible.

When Should Public Debt Be Reduced?

What considerations should guide public debt policy going forward? Should debt be reduced to achieve normative anchors (such as 60 percent of GDP), should it be increased further to finance a big public investment push, or should the existing debt be serviced forever? We argue that, for countries with ample fiscal space (little risk of encountering a fiscal crisis), raising distortive taxes merely to bring the debt down is a treatment cure that is worse than the disease. High public debt of course is costly, but it is a sunk cost only made worse by efforts to pay down the debt through distortionary taxation. Living with the debt is the welfare-maximizing policy. In decisions vis-a-vis the big push for public investment, golden-rule considerations remain salient, with due account taken of the additional servicing costs (and associated distortive taxation) from the resulting buildup of public debt.

Efficiency, Welfare, and Political Competition

We study political competition in an environment in which voters have private information about their preferences. Our framework covers models of income taxation, public-goods provision or publicly provided private goods. Politicians are vote-share-maximizers. They can propose any policy that is resource-feasible and incentive-compatible. They can also offer special favors to subsets of the electorate. We prove two main results. First, in a symmetric equilibrium, policies are surplus-maximizing and hence first-best Pareto-efficient. Second, there is a surplus-maximizing policy that wins a majority against any welfare-maximizing policy. Thus, in our model, policies that trade off equity and efficiency considerations are politically infeasible.

Intellectual Property Rights, Institutional Quality and Economic Growth

We consider the role of intellectual property rights (IPRs) in a Schumpeterian growth model in which patent holders face the threats of profit loss due to imitation and complete replacement due to successful outside innovation. In this setting stronger IPR enforcement has both imitation and innovating deterring effects. We disaggregate IPR policies by distinguishing between two features of IPRs protection. The first is the intensity of IPR enforcement, which is determined by the fraction of resources allocated to innovation and imitation deterrence. The second is the quality of the IPR regime, which reflects the ability of the IPR regime to shift enforcement resources away from innovation deterrence and towards imitation deterrence. We find that an increase in the quality of the IPR regime unambiguously promotes growth. However, an increase in the intensity of IPR enforcement increases growth if and only if the threat of imitation is above a threshold level. We show that there exists a growth-maximizing level of IPR enforcement intensity, which is decreasing in institutional quality. We also show that countries with sufficiently low quality institutions will be trapped in a no-growth boundary equilibrium, regardless of the intensity of IPR enforcement. Simulation exercises indicate that welfare-maximizing policies follow patterns similar to growth-maximization policies. The economy can have too much or too little IPR enforcement intensity. For countries with sufficiently low institutional quality, welfare is maximized by completely foregoing IPR protection and eliminating monopolistic markets, even though positive growth may be feasible with appropriate intensity of IPR enforcement.

Asset Revaluation Regulation with Multiple Information Sources

ABSTRACT: We examine the design of asset revaluation policies in settings where a regulator can mandate fair value disclosure in order to mitigate a lemons problem in the asset resale market. The welfare-maximizing policy generally prescribes fair value certification for the lower asset values and (less costly) historical cost reporting for the higher asset values. The potential for voluntary certification can reduce welfare by increasing equilibrium certification costs and promoting underinvestment in socially valuable projects. Thus, a single regulated source of information (mandated disclosure) can be preferable to two sources of information (mandated and voluntary disclosure).

Clientelism and aid

Using a model of probabilistic voting, we analyze the impact of aid on the political equilibrium in the recipient country or region. We consider politicians with mixed motives: they are interested in promoting social welfare but also value the benefit of holding office. We label as clientelistic the politician who most values the benefit of being in power. We find that the impact of aid on the political equilibrium and therefore on the quality of policy in the recipient country (using utilitarian social welfare as a benchmark) ultimately depends on the value of the elasticity of the marginal utility of consumption. When elasticity is low, the expected policy outcome gets further away from the socially desirable policy set. This substitution of policy quality for aid can help to explain the poor performance of aid in improving policy. Perhaps more surprising is the opposite case, which arises for high values of elasticity of marginal utility: an increase in aid tilts the equilibrium policy towards the welfare-maximizing policy set.

Discretion and the Transmission Lags of Monetary Policy

Monetary policy transmission lags create credibility problems for the inflation-targeting policy maker who acts under discretion. We show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflation-targeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. We find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags.

Visiting Frank P. Ramsey: The Public Finance Concept of Optimal Monetary Policy

Nowadays monetary economists derive optimal policies by solving a Ramsey problem. In this paper I explore the historical context in which this concept of optimality emerged. This approach developed from two ideas. First, economists characterized inflation as a tax on money holdings in the postwar period. This idea is strongly associated with members of the University of Chicago such as Milton Friedman and Martin Bailey, who brought to monetary economics arguments about economic efficiency. The next step was taken by Edmund Phelps who developed a second-best version of Friedman's argument. Welfare-maximizing monetary policies were then formulated by using concepts and tools from the public finance literature. I discuss how monetary economists not only borrowed tools from public finance but also claimed one of its giants as their own: the Cambridge mathematician Frank Ramsey. In my narrative I first discuss Ramsey's original contribution to optimal taxation; I then analyze the circumstances in which Ramsey was rediscovered in the public finance literature in the late 1960s and early 1970s; finally, I study how monetary economists borrowed tools and heroes from public finance in the 1970s. Here also I ponder the current use of Ramsey optimality in monetary economics.