No Regret Fiscal Reforms (Job Market Paper) Draft
Abstract: This paper studies time-inconsistency issues in fiscal policy. How should fiscal policy react to shocks ex-post while preserving incentives to work and save ex-ante? The usual approach involves the government’s commitment to a planned (contingent) fiscal policy, hence forbidding any future fiscal reforms. Noting that fiscal reforms per se are an issue only when they can make households regret their past decisions, I introduce “No Regret Fiscal Reforms”: the government has the discretion to change its (deterministic) planned fiscal policy provided households do not regret their past decisions. Hence adaptability to shocks is provided and incentives to work and save are preserved, without using contingent fiscal policies. Such reforms can be achieved by changing taxes on both capital and labor such that wealth effects exactly compensate for substitution effects. In a representative agent framework, I study how a benevolent government optimally uses No Regret fiscal reforms. I make comparisons to the optimal contingent policy. In the absence of shocks, both approaches yield the same policy, allocation, and welfare. Thus, No Regret fiscal reforms fully address time-inconsistency. With shocks, the two yield very similar policies and allocations but No Regret reforms entail very small welfare losses. Then, I consider robustness to Near-Rational Expectations i.e. the government is uncertain of the households’ beliefs about the distribution of shocks and implements a policy robust to this uncertainty. No Regret fiscal reforms are fully robust to this departure from rational expectations. Finally, I characterize No Regret fiscal reforms with wealth and skill heterogeneity.
