No Regret Fiscal Reforms

By Pierre-Édouard Collignon

http://d.repec.org/n?u=RePEc:crs:wpaper:2021-20&r=dge

How should fiscal policy react to shocks ex-post while preserving incentives to work and save ex-ante? The standard solution involves a commitment to a contingent policy, whereby the initial government sets all the policies for all future states of the world. Contingent policies are unrealistic. As an alternative, I introduce ”No Regret Fiscal Reforms”: the government has the discretion to change its fiscal policy provided households do not regret their past decisions. Hence flexibility is provided and incentives to work and save are preserved. Such reforms can be achieved by changing taxes on both capital and labor such that wealth effects exactly compensate substitution effects. In a representative agent framework, I study how a benevolent government uses No Regret fiscal reforms and I make comparisons to the optimal contingent policy. Both approaches yield very similar policies and allocations but No Regret reforms entail a small welfare loss. Second, 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.

The idea here is that households’ decisions are not influenced by what the government does. In other words, households are completely insured against the government’s actions. Fine, but isn’t the role of government to have an impact on household decisions, that is, be relevant? I am confused.

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