Elsevier

Economic Analysis and Policy

Volume 55, September 2017, Pages 179-193
Economic Analysis and Policy

Full length article
A comparison of fiscal rules for resource-rich economies

https://doi.org/10.1016/j.eap.2017.05.004Get rights and content

Abstract

This paper produces a normative evaluation of fiscal rules for a resource-rich economy. Ad hoc fiscal rules might imply substantial welfare costs; the goal is to analyze the magnitude of these costs by quantitatively evaluating the relative welfare sub-optimality of these rules. I posit a closed form solution for the infinite horizon consumption problem of the planner of a resource-rich economy with resource price uncertainty and precautionary saving. The model is subsequently calibrated and simulated to provide a welfare-based comparison between the fiscal rules based on the Permanent Income Hypothesis and on the ad hoc Bird-in-Hand policy. The results of the simulation indicate the presence of a positive and substantial welfare loss suffered from switching to the Bird-in-Hand rule. This result is shown to be robust under different parameterizations.

Introduction

The motivation of this paper is to shed light on a particular aspect of the more general wealth management problem for resource-rich economies, namely, the design of a fiscal consumption rule in order to minimize welfare losses from risky resource income. In order to do so, this research produces a normative comparative analysis of fiscal rules in a resource-rich economy. Fiscal rules can be either a theoretical derivation or of the ad hoc type. Ad hoc rules might produce sub-optimal welfare results; the aim of this work is to analyze the magnitude of the welfare costs by evaluating the relative welfare optimality of two different benchmark rules. The model of this paper builds on the analogy between the intertemporal consumption problem of an infinitely lived representative consumer who receives an uncertain labor income Caballero (1990), Bodie and Samuelson (1992) and that of a social planner for a country that receives an uncertain income stream from its exhaustible resource stock. The extensive literature on life-cycle saving and permanent income (LC-PIH) started by the seminal work of Modigliani and Brumberg (1954) states that a consumer who receives such an income stream will simply spend the return of the present discounted value of his entire wealth. Holding the value of the income (stock) fixed, the actual timing of the income stream (flow) becomes irrelevant. This suggests that only the amount of the resource wealth might actually matter for the government that is behaving as a permanent income consumer.

Notwithstanding the increased attention to these topics in the literature of natural resource management economics, there is as yet no consensus on how governments of countries with substantial amounts of exhaustible natural resources should design their policies in order to optimally spend their resource revenues. As argued by van der Ploeg (2011), Frankel (2010) and Deacon (2011) in their surveys of the resource curse literature, governments have often overestimated revenues and dangerously relied on the inflated version of their budget constraints (consisting of overall fiscal surpluses), thereby incurring sustained budget deficits which could prove difficult to reverse once income from resources starts to become depleted. In order to avoid this result, some resource-rich countries have implemented more prudent ad hoc fiscal rules, in order to reduce discretion in spending rules and, in turn, the associated macroeconomic risks. The current paper will focus on the case study of the spending fiscal rule in Norway. The applicability of these rules is limited to countries in which domestic political authorities have full control over the resources and, in addition, accountability for rules governing the resources also is ensured. In order to be effective, fiscal rules need to be backed by a strong political will and complemented by efficient administration.

Spending behaviors in resource-rich economies have been extensively analyzed at the empirical level. Villafuerte and Lopez-Murphy (2010) documented fiscal policy behavior in 31 oil-producing countries during the oil price cycle of 2000–2008. Through decomposition of the non-oil primary government balance into a cyclical and a structural component, they find that fiscal policy has been pro-cyclical during the boom period and has contributed to the volatility of business cycles. The degree of pro-cyclicality has been high for low-income countries and low for high-income countries. Villafuerte and Lopez-Murphy (2010) conducted a sustainability analysis estimating the effects of a sudden drop of the resource price on fiscal budgets. They conclude that financing these fiscal deficits might constitute a problem for those countries that did not precautionarily accumulate foreign assets and international reserves during the boom period. Gelb and Grasmann (2010) also confirm empirically the finding that oil exporters alternate periods of booms with periods of declining GDP as a consequence of price cycles.

Turning to the theoretical literature, Bems and de Carvalho Filho (2011) develop a model with resource price uncertainty in order to compute the magnitude of the precautionary savings motive for a large sample of resource-rich economies. Their model is solved numerically and the results show the positive significance of the precautionary savings motive. Building on the stylized framework for oil-producing small open economies provided by Engel and Valdes (2000) and Maliszewski (2009) has computed numerically the relative welfare gains of different fiscal rules. At first, he simulates random realizations of oil price series in order to obtain the paths for government expenditures under the various fiscal rules considered. Then, he ranks fiscal rules by comparing the values that these expenditure paths imply for the mean of the social welfare function. Another approach is that of Pieschacón (2009), which analyzes the effects of implementing different sustainable fiscal rules in a dynamic stochastic general equilibrium model with a deteriorating oil sector.

The present paper contributes to the existing literature in two ways. First, a closed-form analytical solution for the infinite horizon consumption problem of the social planner with resource price uncertainty and precautionary savings is presented. This makes it possible to draw clear theoretical implications by avoiding the black-box effect of numerical analysis. This result is made possible by the specific assumption of Constant Absolute Risk Aversion (CARA) utility for the representative agent. In addition, the model is calibrated and simulated, based on a stylized case study of the Norwegian economy, to provide a welfare-based comparison between the fiscal rules based on the Permanent Income Hypothesis (PIH, hereafter) and on the ad hoc Bird-in-Hand (BiH, hereafter) policy. The results indicate the presence of a substantial welfare loss suffered from switching from the PIH rule to the ad hoc BiH rule. In addition, sensitivity tests prove the robustness of this result under different parameterizations.

Although the nature of the paper is primarily that of a theoretical contribution, there are important policy implications for resource-rich countries that intend to follow the same path as regards resource revenues management, as the Norwegian government did. A brief history of the Norwegian sovereign wealth fund and its relationship to the two stylized fiscal rules of the model is discussed in the course of the paper. In brief, one can hypothesize that the establishment of the Norwegian sovereign wealth fund in 1996 was inspired by the PIH. On the other hand, the subsequent adoption of some aspects of the BiH rule in 2001 for the management of the Norwegian oil fund makes it possible to consider that the Norwegian spending rule incorporates today features of both the PIH and the BiH spending rules. Hence, analyzing the two fiscal spending rules and simulating them in order to estimate the relative welfare loss from adopting the sub-optimal one, contributes to highlight the functioning of the two rules. This can in turn deliver a broad set of policy implications to any other country interested in following the path of the Norwegian sovereign wealth fund.

The structure of the paper is organized as follows: Section 2 introduces the model, Sections 3 The permanent income policy, 4 The Bird-in-Hand policy present the PIH and the BiH rules, and Section 5 evaluates welfare under both rules, whilst Section 6 draws the conclusions.

Section snippets

The model

I model the intertemporal consumption problem of a representative agent economy that receives a stochastic resource windfall. In other words, I look at the consumption problem of the planner of an economy that lasts infinite periods, during which a strictly positive but uncertain exogenous resource income is received. The model is in discrete time. The planner’s objective is to choose the optimal level of consumption of the only (public) good in order to maximize the infinite sum of the agent’s

The permanent income policy

Let us proceed to derive the fiscal spending rule based on the PIH, in other words, the optimal consumption function of the maximization problem presented in Section 2. The value equation for the problem is given by: V(At)=maxgtu(gt)+βEtV(At+1).A standard solving procedure with the help of the envelope theorem gives the classic Euler equation for the marginal utilities of consumption (see Appendix A.b for details): u(gt)=βREtu(gt+1).Let us now observe how the introduction of income

The Bird-in-Hand policy

As opposed to the theoretical and forward-looking spending rule based on the PIH, a few countries have recently adopted ad hoc fiscal rules to govern the use of their resource income. These pragmatic and highly operational rules are intended to reduce the pro-cyclicality of fiscal policy and to direct the use of the resource revenues toward long-term sustainability objectives. The BiH rule is supposed to limit the macroeconomic impact of resource revenues by smoothing the spending path of these

The evaluation of fiscal rules

Let us proceed with the evaluation of fiscal rules. Cochrane (1989) pioneered the study of the utility costs of alternative decision rules. He pointed out that consumption patterns that deviate from the optimal permanent income consumption rules, but incur only in trivial utility costs, can be labeled as near-rational. In the current work, however, the two fiscal rules cannot be simply considered as deviations from each other.

The simplest approach to conduct a welfare comparison between the two

Concluding remarks

The background motivation of this research was to focus on a particular aspect of the wealth management problem for governments of resource-rich economies. Resource wealth gives rise to uncertain income paths, creating the need to design fiscal consumption rules that minimize welfare losses. In order to expand the literature on the economics of natural resource management, this paper constructed a simple model of an economy endowed with a stochastic income from exhaustible natural resources.

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    The author is grateful to Egil Matsen and Ragnar Torvik, as well as Timo Trimborn, Valentin Chabaud, Paolo Piacquadio and Rune Skarstein, for fruitful comments and helpful and interesting discussions.

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