Fiscal Policy over the Real Business Cycle: A Positive Theory (PDF)

This paper extends the political economy model of Battaglini and Coate (2008) to analyze the cyclical behavior of fiscal policy. The theory predicts that, in the short run, fiscal policy can be pro-cyclical with government debt spiking up upon entering a boom. However, in the long run, fiscal policy is countercyclical with debt increasing in recessions and decreasing in booms. Government spending increases in booms and decreases during recessions, while tax rates decrease during booms and increase in recessions. In both booms and recessions, fiscal policies are set so that the marginal cost of public funds obeys a submartingale. The correlations between fiscal policy variables and national income implied by the theory are consistent with much of the existing evidence from the U.S. and other countries, and data on tax rates from the G7 countries supports the submartingale prediction.