Optimal fiscal policy in a small open economy with limited commitment

a r t i c l e i n f o We introduce limited commitment into a standard optimal fiscal policy model in small open economies. We consider the problem of a benevolent government that signs a risk-sharing contract with the rest of the world, and that has to choose optimally distortionary taxes on labor income, domestic debt and international transfers. Both the home country and the rest of the world may have limited commitment, which means that they can leave the contract if they find it convenient. The contract is designed so that, at any point in time, neither party has incentives to exit. We define a small open emerging economy as an economy where the limited commitment problem is active in equilibrium. Conversely, a small open developed economy is an economy in which the commitment problem is not active. Our model is able to rationalize some stylized facts about fiscal policy in emerging economies: i) the volatility of tax revenues over GDP is higher in emerging economies than in developed ones; ii) fiscal policy is procyclical in emerging economies; iii) emerging economies may " graduate " from procyclical fiscal policy and adopt countercyclical policies in the long run. The international evidence on tax revenues suggests that tax revenues over GDP are more volatile in small open emerging than in small open developed economies: Fig. 1 shows the coefficient of variation of tax revenues over GDP for 28 developed economies (in red) and 25 emerging economies (in blue) for the period 1997–2009. 1 From this figure , we can conclude that the coefficient of variation of tax revenues over GDP in small open emerging economies almost doubles that of small open developed economies. 2,3 Moreover, small open emerging economies tend to display procyclical fiscal policy. The fact that government expenditure appears to be procyclical in emerging economies, whereas it is countercy-clical or acyclical in developed economies, has been well documented in the literature. 4 In addition, in a recent paper, Vegh and Vuletin (2012) construct a novel dataset on tax rates for a large set of countries and a long time span. They find that tax policy is acyclical in industrial countries but procyclical in developing countries. A second finding of Vegh and Vuletin (2012), in line with the evidence presented before, is that tax rates are more volatile in developing than in industrial countries. 5 In this paper …