Optimal Penalties on Deviations from Budgetary Targets

Abstract

Beyond traditional arguments justifying the introduction of fiscal rules, this paper analyses their potential contribution to an indirect budgetary coordination between the member countries of a monetary union. Indeed, thanks to appropriate fiscal penalties, the noncooperative and decentralized equilibrium could get closer to the optimal equilibrium where the budgetary authorities cooperate. Our macroeconomic model shows that whatever penalty on the structural budgetary deficit would be optimal in case of asymmetric shocks. A moderate penalty on the excessive indebtedness level would be optimal in “normal times,” or in case of asymmetric shocks if openness to trade and price flexibility are sufficiently high, whereas the share of public consumption in GDP, taxations rates, and indebtedness levels is sufficiently weak in the monetary union. Besides, in case of symmetric shocks, a fiscal penalty would be useful to decrease the excessive budgetary activism, even if it doesn’t allow reaching the optimal and first-best equilibrium. Furthermore, the fiscal penalty should always be an increasing function of the share of public consumption in GDP and of taxation rates but a decreasing function of the strength of automatic stabilizers, of openness to trade, and of price flexibility in the member countries of the monetary union.