The Case for Restricting Fiscal Policy Discretion

This Paper studies how discretionary fiscal policy affects output volatility and the rate of economic growth. Using data on fifty-one countries we isolate five empirical regularities: (1) Governments that use often fiscal policy make their economies volatile; (2) The use of fiscal policy is explained to a large extent by the presence of political constraints and other political and institutional variables; (3) The volatility of output induced by discretionary fiscal policy lowers economic growth by 0.6 percentage points for every percentage point increase in volatility; (4) There is evidence that the increase in volatility is in part due to electoral cycles; nevertheless, we do find that political constraints restrain fiscal policy beyond their impact on the traditional election-year volatility; (5) Rules-based fiscal policy identified by the degree of automatic stabilizers in the economy helps to stabilize business cycles. The evidence in the Paper argues in favour of imposing institutional restrictions on governments as a way of reducing output volatility and increasing the rate of economic growth.