Structural reforms, public investment and the fiscal stance: A prudent approach

The standard theory of tax smoothing says that the government runs a deficit to finance investment projects with a market rate of return and temporary high levels of public consumption. Taxes are used to finance permanent spending and losses on public investment. Deficit financing is used to offset some of the short-run costs of structural reforms. A prudent government deliberately downplays expected future national income and the tax base. As a precaution, the minister of finance sets the tax rate higher and the level of public spending lower. As a result, income and the tax base turn out to be bigger than budgeted, so that the finance minister enjoys windfall revenues and can gradually reduce debt and debt service over time. This permits, depending on political preferences, either gradual cuts in the tax rate or gradual increases in government spending. A prudent finance minister exaggerates project costs and downplays future returns on public investment, hence borrows less. He also downplays long-run gains of structural reforms, so is less inclined to relax budgetary policy. Prudence can offset the intertemporal spending, tax and debt biases resulting from common-pool distortions. If the minister of finance has as many voting rights as the spending ministers combined, the intratemporal common-pool distortions of an excessively large public sector are eliminated as well. A strong and pessimistic minister of finance can thus control the impatient profligacy of squabbling spending ministers. We warn that, if voters care about outcomes on election eve, prudence may be abused for short-run electoral gains. Studier i finanspolitik 2008/3 5