Fiscal Rules as Bargaining Chips

Most fiscal rules can be overridden by consensus. We show that the possibility of override does not make fiscal rules ineffectual. Fiscal rules can lead the party in power to offer spending concessions to the opposition to avoid their application. Since fiscal rules determine the outside option in case of disagreement, the opposition uses fiscal rules as “bargaining chips”. This reduces the incentive for inefficient debt accumulation. We analyze three standard fiscal rules: government shutdown, budget balance and mandatory spending, and show that when political polarization is high, a government shutdown provision maximizes the bargaining power of the opposition and leads to a sizeable reduction of debt. When the degree of polarization is low, a balanced budget rule is preferable. Mandatory spending eliminates the incentive to over-accumulate debt by reducing political risk. However, it gives a considerable advantage to the initial incumbent, generating large and persistent static inefficiencies.