Fiscal Rules as Bargaining Chips

Abstract

Abstract Most fiscal rules can be overridden by consensus. We show that this does not make them ineffectual. Since fiscal rules determine the outside option in case of disagreement, the opposition uses them as “bargaining chips” to obtain spending concessions. We show that under some conditions this political bargain mitigates the debt-accumulation problem. We analyse various rules and find that when political polarization is high, harsh fiscal rules (e.g. government shutdown) maximize the opposition’s bargaining power and lead to lower debt accumulation. When polarization is low, less strict fiscal limits (e.g. balanced-budget rule) are preferable. Moreover, we find that the optimal fiscal rules could arise in equilibrium by negotiation. Finally, by insuring against power fluctuations, negotiable rules yield higher welfare than hard ones.