Fiscal policy as insurance

The goal of fiscal policy is at the macroeconomic level to steer the economy towards efficiency and, depending on the country, to smooth somewhat economic fluctuations. It has long been debated whether this is desirable or possible at all, given the large delays in implementing public expenses. But changes to tax policies are quicker to put in place and implement. At the microeconomic level, the focus is more on the long term, again try to attain better efficiency as well to optimize some definition of fairness across economic agents, however this may be defined in the respective countries. These micro and macro aspects have largely been regarded as separate. This does need to be so.

Eduardo Engel, Christopher Neilson and Rodrigo Valdés look at the particular fiscal policy of Chile. This country is characterized, like many emerging economies, by wild fluctuations in economic activity. In this case this is triggered by changes in commodity prices, in particular for copper. The most important implication is that government revenue varies wildly (a macroeconomic impact) between 1 and 8% of GDP, which changes Chile's ability to redistributes across heterogeneous households (a microeconomic impact). Adhering to a balanced budget rule would have a dramatic effect, in terms of aggregate welfare it would be like renouncing to half of the copper revenue. The reason is that households' incomes is also correlated with copper revenue, and a countercyclical policy is then optimal. And to be the most effective, the poorest households are helped in hard times, both because they have the highest marginal utility from consumption and because they have the highest propensity to consume.

Chile has been pursuing so far something that is close to a balanced budget rule: expenses are related to a permanent income measure of income. This means expenses are relatively constant, except for the last years, where expenses grew significantly despite a reduction in copper prices. This appears to have worked well, in particular because the poor have been the target of this largesse, not the rich. That was stimulus spending done right. This paper shows how this can be done even better.