Rules Versus Discretion

When comparing a discretionary policy and automatic stabilizers, it is useful to evaluate each tool from the viewpoints of rules and discretion. The issue of rules versus discretion could be discussed from the perspective of dynamic or time inconsistency. The optimal policy at present may not be optimal after time has passed and the economic situation changes. This is called dynamic (or time) inconsistency.

For example, suppose the government promises to conduct a certain policy in the future. However, the policy may not be optimal when the economic situation changes in the future and the government reconsiders the optimization problem. Such a policy may be called time inconsistent.

In a dynamic world, an asset accumulated in the present is a stock variable; thus, it is initially given at this point. Taxing the asset constitutes a lump sum tax; hence, the tax does not affect private agents and revenue can be collected without any distortionary costs. Since an asset is a stock variable, raising tax rates results in raising revenue. However, if the government imposes a high tax rate from the beginning, it raises the cost of asset accumulation and depresses the incentive to save. Thus, the optimal policy is that the government promises not to tax asset accumulation from the current date; then, once the asset is sufficiently accumulated, the government raises tax rates to collect tax revenue.

When the future arrives, the promise of zero tax is undesirable for the government. By raising tax rates on assets, the government may reduce other distortionary taxes, which is desirable for resource allocation. Since the government intends to maximize the social welfare of households, it has an incentive to break the promise in order to improve social welfare. The initial promise of maintaining zero tax in the future is not time consistent simply because the policymaker has an incentive to break it in the future.

If the private sector does not pay attention to the government’s future action, the dynamic inconsistency problem does not create any costs. By breaking the promise, the government can increase social welfare. However, it is plausible to assume that the private sector will pay attention to future government behavior; thus, the credibility of policy matters. Chapter 13 discusses this issue from the viewpoint of time inconsistency.

When a policymaker faces dynamic inconsistency, the policymaker changes a policy after a certain time. Sooner or later, the private sector may begin to anticipate such policy changes. For example, once the private sector anticipates future increases in tax rates, this depresses private savings immediately. Hence, a policy of zero tax in these circumstances does not stimulate savings. As a result, social welfare may amount to less expenditure than when the policymaker does not raise tax rates in the future. Thus, it may be desirable to restrict the freedom of policy options in the future with rules. This is an example of why rules can be better than discretion.

Thus, it may be more desirable to adopt predetermined rules as fiscal policy rather than conduct discretionary fiscal measures. By doing so, we may attain more stable macroeconomic activities. For example, a rule may be to increase public investment at a given growth rate. Moreover, the built-in stabilizer of the fiscal system is a typical example of non-discretionary fiscal policy. The built-in stabilizer affects macroeconomic activities counter-cyclically and instantaneously, so it certainly stabilizes aggregate demand fluctuations. Considering the uncertain lags of discretionary measures, it may be desirable to use the built-in stabilizer more than discretionary measures.

From the viewpoint of Keynesian economics, discretionary measures are desirable because the government can anticipate lags of policy; thus, the size of the multiplier should be significantly large. However, from the viewpoint of neoclassical economics, rules are desirable because the government cannot anticipate lags of policy correctly; thus, the size of the multiplier should be significantly limited. Since discretionary measures produce distortions, it is better for the government not to conduct any discretionary measures even in a recession unless the recession is permanent.

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