Tax Smoothing Discretion Versus Balanced Budget Rules in the Presence of Politically Motivated Fiscal Deficits: The Design of Optimal Fiscal Rules for Europe after 1992

We analyse the arguments in favour and against binding fiscal rules such as those recently agreed by European countries as preconditions for participation in the third phase of the European Monetary Union. The evidence in the paper suggests that a number of EC countries are following unsustainable fiscal policies and that this `deficits bias' may be partly due to political distortions. Binding balanced budget rules would eliminate the deficits bias that appears in the presence of such distortions, but would also prevent the use of potentially beneficial tax-smoothing budget deficits in response to transitory shocks. More flexible fiscal rules enforced by credible sanctions against deviant countries appear to be superior to rigid balanced-budget rules and discretionary equilibria.