Fiscal policy over the real business cycle: A positive theory

This paper presents a political economy theory of the behavior of fiscal policy over the business cycle. The theory predicts that, in both booms and recessions, fiscal policies are set so that the marginal cost of public funds obeys a submartingale. In the short run, fiscal policy can be pro-cyclical with government debt spiking up upon entering a boom. However, in the long run, fiscal policy is counter-cyclical with debt increasing in recessions and decreasing in booms. Government spending increases in booms and decreases during recessions, while tax rates decrease during booms and increase in recessions. Data on tax rates from the G7 countries supports the submartingale prediction, and the correlations between fiscal policy variables and national income implied by the theory are consistent with much of the existing evidence from the U.S. and other countries. Marco Battaglini Department of Economics Princeton University Princeton NJ 08544 [email protected] Stephen Coate Department of Economics Cornell University Ithaca NY 14853 [email protected] We thank Andrea Civelli and Woong Yong Park for outstanding research assistance. For helpful comments, we also thank Ulrich Muller, Christopher Sims, Ivan Werning and seminar participants at Georgetown, Johns Hopkins, ITAM, University of Miami, NBER, Princeton, Simon Fraser, the X Workshop in International Economics and Finance at Universidad Torcuato Di Tella, and York University.