Abstract(s)
The design of a fiscal rule involves a trade-off between committing governments to
a fiscally responsible budget and giving governments the discretion to respond to
shocks. What is the optimal degree of discretion for deficit-biased governments that
are facing shocks to their fiscal needs? The tail of the distribution of shocks determines the optimal degree of discretion. If the tail is thin, an optimal rule features a cap
on public spending enforced by off-equilibrium sanctions. If the tail is thick, an optimal rule grants more discretion than a cap could achieve at the cost of on-equilibrium
sanctions. An optimal rule featuring on-equilibrium sanctions also features a threshold below which public spending is exempt from sanctions. The optimal exemption
balances a loss of discipline on low levels of spending with an economy of sanctions
on high levels of spending. These findings suggest avenues to reform the Stability
and Growth Pact.