Budget inflexibility

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Budget inflexibility

    Budget inflexibility


    Juan Carlos Echeverry

    Leopoldo Fergusson

    Pablo Querubín

    Universidad de los Andes

    Facultad de Economía-CEDE


    The study of budgetary institutions has long been an important topic in the economic literature. Nonetheless, the degree of rigidity or inflexibility in budget preparation, a prime preoccupation for policy makers and in particular for finance ministers since a long time ago, has been relatively unexplored. In this paper we show that budget inflexibility can take several forms and argue that it is likely to be closely related to various types of political conflict present in the budget process. Moreover, we study one particular form of budget inflexibility and its connection with one specific (but perhaps the most important) political force driving the budget process. More specifically, we discuss some of the consequences of "expenditure inflexibility," defined as the existence of transfers to special interests enjoying constitutional or legal protection which impede their modification in the short run, in a simple model of legislative bargaining that captures the Tragedy of the Commons present in public budget allocation.

1. Introduction

    Fiscal sustainability has been a prime preoccupation for developing economies for as far as there is a record of public finances and macroeconomic behavior. Most of the macroeconomic crises episodes have been characterized by public debt service problems, in turn related to excess expenditures or negative shocks to tax revenues. The reasons lie in the fact that emerging economies face considerable demands for aggressive public expenditure programs in order to respond to social aspirations on health, education, aqueducts, sanitation, roads, power generation and telecommunications, and finally social programs for the old, the unemployed and other vulnerable strata of population. Such expenditure programs have a structural character and can hardly be removed in the short run, when the public finances come under stress. If the country is temporarily blessed by access to world or domestic capital markets, the solution is the accumulation of public debt, which as time passes, and interest rates start to reflect the vulnerable financial position of sovereign credit, becomes itself an aggravating element. Indeed, weak financing structures, normally denominated in hard currencies, and short maturity expose fiscal finances to devaluation and sudden stops in public debt roll-over.

    In order to tackle stubborn growth underperformance and macroeconomic instability, during the nineties many Latin American countries adopted so-called market oriented reforms aimed at reducing the degree of state intervention on their economies, allowing goods and services' prices to be set by market forces, simplifying tariff


    structures, cutting inflation and granting central bank independence, boosting competitiveness and exports, opening room for private participation on sectors traditionally secured to public ownership, like utilities, decentralizing government and allowing capital flows a freer movement. These reforms implied a clearer focus for public sector intervention, specially oriented to wealth redistribution and poverty reduction. The new, narrower scope of the public sector and the enhanced role of sub-national public administration entities were thought to bring closer the public resources allocation decision to people who knew best their needs and could make the public officials accountable.

    In spite of the original appeal of this set of reforms and the trust on their positive impact on the economy, the macroeconomic vulnerability did not decline, and in some instances increased as short term capital flows made real and nominal variables fluctuate sharply in very short spans. In the favorable ambiance of the beginning of the nineties, public expenditure found windows of opportunity in the international capital markets to finance expenditures above short term revenues. However, a sequence of international crises set off by the 1994 Tequila Crisis and hopefully terminated by the December 2001 Tango crisis, the biggest default of public debt witnessed in history, created a quite unstable international environment. The effect of reforms was tarnished by a series of external shocks that impeded these economies to perform up to the expectations.

    Huge intellectual efforts have been devoted to tackle the issue of restoring credibility to public policies in these economies, to design credible strategies for reforming taxes, increasing revenues (i.e. improving the efficiency of the tax collection agencies), or reforming budgetary institutions. Following the example of seemingly successful fiscal framework adopted by the Clinton administration at the beginning of the nineties, many countries took to congress and approved the so-called Fiscal Responsibility Laws, also championed by the multilateral institutions. Such codes proposed a set of rules aimed at medium and long term fiscal sustainability. Most of the measures adopted consisted simply on making explicit the long term consequences of current expenditure and fiscal imbalances, the financial costs associated with borrowing, and the sustainability conditions of observed public debt levels. However promising and stable these laws looked at the outset, most of them could be reformed by the yearly budget law and could not avoid the issuing of new laws mandating expenditure. In democratic societies congresses would, and probably should, never surrender its competence for issuing expenditure-mandating laws. Hence, the fiscal responsibility framework depicted by such laws was as strong as the institutional consensus for fiscal prudence within their democratic institutions. Such consensus proved weaker than originally thought. Indeed, efforts to balance the budgets have systematically under-performed vis-à-vis the voracity of the executive and the legislative.

    Facing the capacity of the legislative for creating new expenditures and protecting them via law and constitutional stipulations, the economic authorities' attention turned from the aggregate imbalances to understanding the micro-structure of public expenditure. Short term inflexibility became a prime preoccupation. Many expenditures were protected by law or by the constitution and made quite difficult the rational design of the public budget.

    Furthermore, other worrisome inflexible outlays were found, the so-called skeletons of public finances: infrastructure investment guarantees, established at the boom of such outlays at the beginning of the nineties, when energy PPA, traffic guarantees for roads and assurances on number of calls in telecommunications were provided. Also burdensome and generous pension schemes, which became unsustainable as an aging population was coupled with a decline in the birth rate, and a reduction in young people entering the labor force, affected also by informality and low rates of contribution to pay-as-you-go pension systems. Finally, a series of contingent claims that could turn a sustainable fiscal position into an unsustainable due to changes in court rulings or sudden changes in the exchange rate.

    With this findings, the flow approach to fiscal imbalances was revealed limited since the origin of excess expenditure seemed to be grounded in the balance sheet of the public sector more than in its flow accounts (see Echeverry and Navas, 1999; Polackova and Schick, 2002; Echeverry et al., 2002). Once policy-makers, the academia and the multilateral institutions reached a comprehensive understanding of the variety of problems that plagued fiscal finances in Latin-American economies, it became evident that confronting them would need an


    all-inclusive strategy aimed to tackle deep long-term contracts like pensions, public debt and infrastructure guarantees; revenues side troubles like insufficient value added and income tax bases; tax collection deficiencies, cumbersome tax rates structures and exemptions; and finally the lack of flexibility of public expenditure.

    In contrast to most of the issues mentioned, public expenditure inflexibility has received little attention in the theoretical and applied economic literature. Moreover, although the study of budgetary institutions has long been an important topic for academics, recent research has emphasized the importance of a number of features of the budget process, such as its degree of transparency, the extent of centralization or decentralization of budgetary power in the Executive vis-à-vis the Congress, the role of regions and the central government, and the existence of "balanced budget rules", whereas the degree of rigidity or inflexibility in budget preparation has been relatively unexplored. This paper aims at filling this gap. Budget inflexibilities are known to policymakers and in particular to finance ministers since a long time ago. Indeed, complaints against other members of the cabinet and the congress' insatiable appetite for expenditure are to be found in many old writings of the officials in charge of the 1public finances. Hence, it is remarkable the lack of formal treatment of this issue in the specialized literature. We need a better understanding of the political economy mechanisms behind budget inflexibilities.

    The fact that budget inflexibility is currently an issue concerning policymakers, at least in Latin America, is confirmed by a recent IMF report on the Macroeconomic Perspective of the region since the 1990s. The report points out that budget inflexibility was an important obstacle to imposing fiscal discipline in a number of Latin American countries. It emphasizes that the failure to reform fiscal institutions undermined efforts at fiscal consolidation. Most importantly, underlying weaknesses and rigidities in revenue and spending systems were not addressed. In addition, problems with intergovernmental relationships led to distorted incentives and additional rigidities. As a result, recourse to ad hoc adjustment efforts without dealing with these issues undermined longer-term economic growth prospects, exacerbating sustainability problems." (IMF, 2004, p.73). The report also adds that while the measures creating inflexibility were intended to protect key spending categories, they impaired allocative efficiency and fiscal flexibility. With about 80 percent of public spending in Brazil being nondiscretionary by the end of the 1990s, the ability to adapt to changing macroeconomic circumstances was compromised" (p.63). In another paper (Echeverry et al., 2004) we have studied in detail the case of Colombia and have confirmed this diagnosis.

    But, what exactly is "budget inflexibility"? In general, we can define it as the impossibility for policymakers to change the composition or size of the budget in the short run (whether it be on the revenue or expenditure side) due to the existence of constitutional or legal protection for certain revenues and/or expenditures of the government. Of course, there are a number of additional budget items which are "naturally" inflexible in the sense that the government cannot renege on them except under extreme circumstances. Such is the case of the public sector wage bill, public debt service and pensions. However, budget inflexibility can take many other forms: measures to earmark revenue to specific expenditures, constitutional and legislative mandates setting floors on different types of spending, measures linking expenditures to the movement of certain macroeconomic variables, etc.

    In this sense, one way to classify budget inflexibilities is between inflexibilities stemming from the revenue and the expenditure side. On the revenue side, the most frequent source of inflexibility is earmarking of revenues to specific expenditures (legal mandates whereby the revenue of specific sources is compelled to be destined to particular and predetermined expenses). This is a source of inflexibility in the sense that not all government revenues constitute a single pool of resources which can be discretionally allocated among different uses. A recent noteworthy example from Colombia (where this sort of earmarking is referred to as "rentas de destinación específica") is the "impuesto a la seguridad democrática" (democratic security tax), a tax on wealth to be destined exclusively to military purposes. Another revenue-side inflexibility is the granting of a right to certain

     1In Echeverry et al. (2004) it is shown that, in the case of Colombia, the issue of budget inflexibility was a recurrent subject in

    finance ministers' reports since the nineteenth century. The topic is still a current preoccupation for policy makers, as evident

    from press articles and other statements of recent and current policy makers (see, for instance, Restrepo, 2003, Sanguinés, M. and E. Fernández, 2003, and Hernández, 2003).


    groups/associations to levy taxes to finance their specific activities. Among these so-called "parafiscales" the most frequent example is the granting of these rights to agricultural marketing boards that levy taxes on producers in exchange for services directly related to their productive activities. Consider for instance, the case of the National Federation of Coffee Growers in Colombia. This is clearly a source of inflexibility to the extent that these resources never enter the common pool of tax revenues to be allocated discretionally by authorities.

    On the expenditure side, inflexibilities take the form of mandatory transfers to special interests. These transfers enjoy constitutional or legal protection which impedes their exclusion from the budget or even their reduction in the short run. Typically, the largest items in this category are mandatory and often constitutional 2transfers to subnational governments. However, they also take the form of transfers to narrower and more specific

    interests ranging from associations for the prevention of specific diseases to ethnic minorities. In this paper we will focus on the study of this sort of inflexibility and its role in a model that captures in a stylized manner two key features of the political forces behind the budget process: the tragedy of the commons and the process of legislative bargaining. This is obviously far from a comprehensive analysis of budget inflexibility since, as argued in the following section, budget inflexibility is closely related to all forms of political conflict present in the budget process. Nevertheless, this is a first step in attempting to understand the consequences of budget inflexibility for policy and the political forces behind it.

2. Related literature

    Surprisingly, the topic of budget inflexibility seems to have been overlooked by the academic literature on fiscal policy. Indeed, to our knowledge there is no theoretical work on the effects of budget inflexibility. Thus, although as shown in the introduction practitioners are indeed concerned with the problem, there are little (direct) theoretical grounds to discuss whether budget inflexibility is a desirable or undesirable feature of the budget process. However, the (growing) literature in the field of "new political economy" provides a number of insights regarding the possible origins and (dis)advantages of this phenomenon.

    In this section, we take advantage of some of the recent contributions to the political economy literature on the determinants of fiscal policy to interpret the issue of budget inflexibility. The main conclusion that can be drawn is that inflexibility, like budget issues in general, is likely to be the result of deep political conflicts. Furthermore, political conflict often leads to the adoption of policies that turn out to be economically "inefficient". From this perspective, it is possible to argue that there are several political motivations that might lead, in equilibrium, to "excessive" budget inflexibility. The political economy literature also emphasizes that "institutions"--the set of rules of the game shaping the incentives of economic (and political) agents involved in the budget process--are a key determinant of overall economic results. Thus, another message stemming from this literature is that it is important to modify budget institutions so as to reduce the incentives and opportunities to generate inflexibility, rather than simply eliminate some expenses, which will, most likely, reappear in the future.

    However, from another point of view, it is possible to argue that a certain degree of inflexibility is desirable in that it isolates certain important expenditures from political and fiscal fluctuations. The validity of this argument is examined and criticized in the second part of this section, where we discuss the topic of time inconsistency" in economic policy.

2.1 Political models of fiscal policy

    The literature on the political economy of fiscal policy is hardly new. Yet, recently there has been a renewed interest in incorporating political variables in the explanation of fiscal policy. This interest has been motivated

     2In Colombia, these transfers to subnational governments, channeled through the Sistema General de Participaciones, are not only inflexible in terms of their level. The allocation of transferred resources is also regulated.


    mainly by the fact that strictly economic theories on the way economic policy should behave have been relatively unsuccessful in explaining real-life decision making by policymakers. Of course, this is not surprising since these normative" theories are based upon the premise that the purpose of policymakers is to maximize "social welfare". However, in practice, these decisions arise from the interaction of various groups of society with disparate interests. Political models on the determination of economic policy explicitly incorporate the role of these groups and the implications for resulting policies of their interaction. Moreover, an important contribution of this perspective consists in examining the role that different institutional environments or rules of the game" might have on equilibrium policies.

    As we highlighted earlier, the new political economy has not studied in detail the specific problem of budget inflexibility. Nevertheless, there is a large literature on the political economy of public debt which is potentially useful for analyzing budget inflexibility, since, like debt, inflexible headings in the budget can be interpreted as an obligation that the government acquires with different groups in society. Moreover, purely economic theories on public debt give relatively little justification to the existence of inflexibility, especially if it leads to a persistent excess of expenditure over revenue. Such is the case of the tax smoothing" theory of government deficits which implies that governments should only accumulate debt during wars or recessions in order to distribute over time the costs of distortionary taxation. As shown by Roubini and Sachs (1989) and Alesina, Roubini and Cohen (1992), the experience of OECD economies during the last three decades seems to be inconsistent with this theory which suggests that public debt should serve as a shock absorber in case the economy is hit by unexpected (income or expenditure) shocks. On the contrary, the overall trend in OECD economies has been towards public debt 3accumulation, even during times of peace and economic growth (Alesina and Perotti, 1994). Developing

    countries have also run budget deficits systematically since the 1970s, and this has often led to unsustainable debt accumulation. (Tornell and Velasco, 1995; Larraín and Selowski, 1991). Meanwhile, several empirical studies have found that political variables play a crucial role in the determination of public debt (see, for example, Roubini and Sachs, (1989) for industrialized countries and Edwards and Tabellini (1991) and Roubini (1991) for developing countries).

    For these reasons, it is worth reviewing the political theories on public debt accumulation and try to extract some lessons on the possible political determinants of budget inflexibility. Following Alesina and Perotti (1994), the contributions to this literature can be organized in the following categories:

1) Theories of "fiscal illusion". These theories, best represented by the "public choice" school (Buchanan and

    Wagner, 1977), are based on two crucial assumptions. First, policymakers want to be reelected and to do so

    they use the instruments of economic policy (including running fiscal deficits) to improve economic

    performance before elections. Second, the private sector does not fully internalize the government budget

    constraint and hence believes, that, in fact, running deficits boosts the economy. If, additionally, deficits are

    difficult to cut after elections, this theory may explain the political bias towards debt accumulation observed in

    many countries.

    As noted by Alesina and Perotti (1994), Buchanan and Wagner (1997) argue that different institutions may

    lead to more or less fiscal illusion, and thus to more or less deficit bias. For instance, if groups of voters judge

    politicians' performance in dispersed regions based on the number of public goods and services that are

    permanently awarded to them in the budget, a version of this theory can potentially explain inflexibility. In

    other words, inflexibility could be created by "fiscally illuded" dispersed groups in society that seek for

    permanent benefits from public expenditure without internalizing their cost, whereas politicians concede these

    benefits to gain political power.

    However, there are problems to this approach. On the one hand, in explaining differences in the degree of

     3Barro (1996) argues that the tax smoothing theory seems to fit US data reasonably well, yet Bizer and Durlauf (1990) present evidence which suggest that the political variables are also significant in this case.


    budget inflexibility across countries a question that could be raised is whether these differences can be based on the superior ability of groups in society in some countries to internalize the government's budget constraint or to differences in the degree of opportunism of politicians across countries. Also, it is difficult to explain the timing of the increase in budget inflexibility based on this type of theory: did voters suddenly became illuded or politicians opportunistic?

    2) Debt as a strategic variable. When there is political polarization and elections are held periodically, debt can become a strategic variable if the incumbent does not share the preferences of his opponents (Alesina and Tabellini, 1990). Public debt not only allows the incumbent to spend more resources on the policy he likes best (one type of government will prefer more butter and the other more cannons), but, additionally, debt service limits the resources available for his opponent, if he gets elected. This theory might explain the political bias towards debt accumulation in each period. Additionally, it predicts that public debt will be higher in countries with a higher degree of political polarization, where it is more likely to lose power to an opponent with different or even opposing preferences to those of the party in power.

    This theory can also explain some of the motivations behind the creation of budget inflexibility. In fact, inflexible expenditure can be seen as a strategic variable used by each government, or by different interest groups, to secure the continuity of certain resources that can be threatened by the alternation of political power. The case of Colombia is suggestive, as budget inflexibility increased dramatically in the nineties, a period characterized by a higher degree of political participation and polarization as compared to earlier years. This change in the political panorama, might have increased uncertainty with respect to the continuation of different political groups in power, thereby increasing the incentive to use strategically certain instruments of economic policy--such as public debt or the passing of laws that create inflexibility--as a form of commitment. Figure 1 shows that nearly 50% of the current total earmarked spending was created in the period 1990-1999, whereas close to 30% was created from 1999 to 2002.

    3) Intergenerational conflicts. According to this strand of literature, debt accumulation today generates taxes for those voters who have not been born or have not yet become part of the working or entrepreneurial population and hence are not represented in the political process. This critical difference in political representation of current and future generations generates a bias towards public debt accumulation as current generations try to transfer the costs of a high level of public spending to future generations. When countries experience important changes in their demographic patterns, they run the risk of becoming excessively indebted as a result of the behavior of certain generations. For example, in the case of Colombia, the increase in life expectancy may have exerted pressure on the government's budget in the form increased pensional debt. To many, one of the tasks the government should undertake to tackle its fiscal problem is to reduce its pensional liabilities, particularly in those cases where the benefits of a few turn out to be generationally" inequitable.

    An institutional innovation that would encourage the emergence of this type of generational irresponsibility" would be the creation of a new pensional system in a country. If this rent-seeking technology" emerges in a certain point in time, the first generation could have the incentive to overexploit it, contributing with small amounts but transferring to themselves generous benefits. This seems to be an accurate description of what the generation of workers (predominantly of the public sector) did from the decade of the fifties to the decade of the eighties with the pay-as-you-go pensional system in Colombia.

    Some of the special pensional regimes appear in the nation's budget in the form of inflexible expenses through which certain generations were able to secure for themselves a portion of it. As shown by Echeverry (2002), the increase in Colombia's public debt since the outset of the decade of the nineties is explained mostly by the fact that for decades, a pensional debt had been accumulated by two generations that compelled their sons and grandsons, in their absence of course, to pay these obligations when they reached the age of retirement" (p. 151).

    The problem with this type of debt accumulation, and in general the problem of public finance, does not rest on


    the fact that someone is spending for pleasure or irresponsibility. Rather, that someone is forced to honor some costly contracts which frequently favor a few [and most of which] have been drafted in the Constitution" (p. 157). The fact that these inflexible obligations are disproportionate becomes evident when we compare Colombia's pensional debt to its social debt-the money necessary to insure the basic unsatisfied needs of the entire nation. While the DNP (National Planning Department) estimations? show that the latter represents 67% 4of GDP, Colombia's pension debt is nearly 200% of GDP.

    4) Distributional (intragenerational) conflicts and "wars of attrition". According to this line of research, the

    distributional struggle amongst individuals can delay the adoption of fiscal adjustment. Individuals prefer issuing public debt over fiscal austerity because each one wants to pay a small fraction of the stabilization cost. In other words, even when it is clear for every member of society that there is a need for austerity and that the levels of public debt are unsustainable, stabilizations are delayed because no one is willing to give up the benefits they receive from public spending or to bear the costs of having to pay higher taxes. In this scenario, debt accumulation is the result of a war of attrition" between different interest groups. A distributional struggle between different social groups, each trying to transfer a higher portion of the fiscal burden of stabilization to others (Alesina and Drazen, 1991), delays fiscal austerity and increases public debt.

    This theory might also have some interesting implications for budget inflexibility. Indeed, budget inflexibility may be understood as a formal mechanism of protection against the wars of attrition": the groups that have been able to secure certain resources in an inflexible manner do not run the risk of being the looser" group that has to bear the larger share of the costs of fiscal adjustment. Additionally, this theory coincides with the literature on public debt as a strategic variable, in that debt accumulation will be greater in countries with higher degrees of political polarization, where the war of attrition" will be even more severe. In this setting, it becomes more important for groups to acquire mechanisms of protection, like budget inflexibility, against these contingencies.

    Finally, this theory suggests that the elimination of inflexibility requires a political agreement on when and how the stabilization costs are to be distributed. In the case of budget inflexibility, there ought to be a step previous to this agreement in which social groups are convinced of the importance of eliminating it with the aim of attaining fiscal sustainability.

    5) The Tragedy of the Commons. These theories explain the political bias towards debt accumulation as the

    consequence of the fact that demands of regions or politically dispersed groups are financed out of a common pool" of resources (Weingast, Shepsle, Johnsen, 1991). This is simply an application of the Tragedy of the Commons in which each group worries about obtaining the greatest possible amount of resources without thinking of the aggregate consequences of this behavior. According to this set of theories, differences across countries are explained by the types of budgetary institutions and their capacity to limit the bias towards an excessive level of spending and deficit. This type of argument does not have to be limited to geographical interests nor to public debt. Indeed, in any group of individuals with differing interests and with access to collective owned resources, a tragedy of the commons may arise: the common resource is over-used because each individual tries to get a hold of a slice of the cake" without fully internalizing its financing costs.

    Velasco (2000) develops a model in this vein to explain the phenomenon of excessive public debt accumulation. Though the problem of budget inflexibility is not explicitly considered, some insights underlined by Velasco suggest some hypotheses with regard to the excessive accumulation of inflexible obligations in the budget. In his work, Velasco presents a model in which there are several interest groups, each benefiting from a different type of public expenditure. The government is "weak" in that each interest group can influence the political authorities' decision with respect to the allocation of public expenditure. Also

     4The social debt is defined as the financial cost of covering 100% of population with services such as basic healthcare, housing,

    water and sewage systems, electricity, good roads, universal primary and high school education, doubling the coverage of

    college education, and humane treatment to the prisoners in prisons with rehabilitation facilities.


    importantly, government resources are a common property out of which interest groups can finance

    expenditures on their preferred items. In this setup, transfers turn out to be higher than a benevolent planner

    would choose them to be, fiscal deficits emerge even when there are no reasons for intertemporal smoothing,

    and in the long run government debt tends to be excessively high. If we loosely expand this model in order to

    understand the creation of budget inflexibility, Velasco's predictions turn out to be interesting. The level of

    inflexibility is above the optimum because while benefits are almost exclusively received by each group, the

    financing costs are shared amongst all the individuals in society.

    Also related is the paper by Buchanan and Yoon (2004). Buchanan and Yoon consider a model where

    distortionary taxation is "nondiscriminatory in all respects"; that is, where any tax levied against the general

    income tax base is applied to the incomes of all members of the society. Nonetheless, these general taxes

    finance differential transfers, favoring members of the majority coalition that impose the tax base. The familiar

    "Tragedy of the Commons" arises since the fiscal capacity of the whole economy becomes an exploitable

    resource: separate decisionmakers do not fully internalize the external effects of their decisions on the general

    productivity of the tax base, leading to its possible over-exploitation. That is, the tax rate may be in the "wrong

    side" of the Laffer Curve. Yet, the authors emphasize another element which acts to limit such

    over-exploitation: "membership externalities". According to the authors, the simultaneous actions taken by

    different majority coalitions constraints the majoritarian exploitation of fiscal income: "prospects for

    individual membership in more than one decisive authority will temper the behaviour of the reference member

    of any operative coalition, and without recourse to any relaxation of the rationality postulates" (p. 87).

    6) Budgetary Institutions. In addition to the previous group of political theories of fiscal policy, a number of

    studies have tried to explicitly evaluate the role that budgetary institutions play in the fiscal performance of

    different countries. The emphasis has been on the influence of institutional characteristics, like the type of

    electoral system, the party structure, the fragmentation of the government and the degree of political

    polarization, on aggregate fiscal performance (measured, for example, by the government's deficit), rather

    than on specific topics like that of budget inflexibility (Alesina and Perotti, 1996). Nonetheless, it is clear from

    the theoretical literature that institutions should be important in determining fiscal outcomes and empirical

    work has found that this is indeed the case. Also, just as budget inflexibility might be more likely to arise in

    some institutional frameworks than others, budget inflexibility itself could be considered as a feature of the

    institutional framework affecting fiscal results.

    In sum, this review of the existing literature seems to suggest that budget inflexibility is probably the result of the political conflict underlying the budget process, and that the degree of inflexibility could be "excessive" in equilibrium. However, it is worth discussing possible theoretical arguments in favor of inflexibility. More specifically, to the extent that budget inflexibility reduces the role of discretion in policymaking, the well known debate on the convenience of rules vs. discretion in economic policy can probably shed light on this topic. This debate, intimately related to the concept of time inconsistency which we consider in turn.

2.2 The time inconsistency problem

    The time inconsistency problem refers to the fact that, sometimes, policies that are chosen at a certain point in time for some period in the future, are then considered to be suboptimal and are modified, even though key elements such as preferences and technology remain the same. For instance, a frequently mentioned example of time inconsistency has to do with the incentive a government has to not honoring its debt or the incentive to "inflate away" the real value of nominal debt. Ex ante this policy is suboptimal because, if anticipated by the public

    sector, investors will demand a higher interest rate to compensate for the risk of default. However, ex post, once the

    loan has been made, there is an incentive to renege on debt and thus avoid the costs of paying it back.

    Maybe the most obvious solution to the time inconsistency problem is to abandon discretion by adopting rigid rules for the implementation of economic policy. In this context, inflexibility could be considered an optimal response to the policymakers' incentives. In this vein, budget inflexibility could be understood as a convenient rule whereby policymakers' discretion is limited so that certain expenses are not modified in the future. In this sense,


    the principle governing budget inflexibility is mistrust in the government's commitment to certain obligations.

    Despite the apparent convenience of this type of solution, there are a number of queries regarding its practical implementation. The first element that must be addressed is that, although rules may solve the time inconsistency problem, the existence of unexpected shocks might imply that a certain degree of flexibility or discretion is desirable. One possible answer to this problem is to elaborate contingency rules that establish a course of action for

    each possible "state of nature". However, not all possible states of nature can be foreseen, which means that in reality a complete rule of this sort is virtually impossible. There is also the problem of how to verify the real state of nature and enforce a rule of this sort. For instance, political authorities may be tempted to take advantage of informational asymmetries to argue in favor of certain policies, and thus they end up having discretion. Furthermore, there is likely to be a trade-off between simplicity and enforceability of contingency rules, since more complex rules (which attempt to cover all possible eventualities) are more likely to lead to arbitrary interpretations and hence discretionary behavior in practice.

    An alternative solution is the creation of escape clauses which obliges policymakers to stick by the rules,

    unless something extraordinary or unexpected occurs. To prevent these clauses from being used opportunistically, some sort of cost should be paid when abandoning the rules. An example of escape clauses is the concession of special powers to the executive branch during exceptional situations such as "states of siege". The cost that governments must pay for applying these escape clauses can be, for example, a certain procedure in Congress. Nevertheless, the practical implementation of these rules is not always simple. Again, as rules become more complex, they are more open to interpretation and escape clauses could be abused. If a government can declare the State of Siege relatively easy and draft decrees and take measures under the protection of the faculties granted by this condition, rules that try to limit the policymakers' degree of discretion become futile.

    Although there are a number of applications of the rules vs. discretion debate to fiscal policy, the literature has focused on the convenience of having actively countercyclical fiscal policy. In general, the message that emerges from this literature highlights the inconvenience of discretion to stabilize production (i.e. Auerbach, 2002; Fatás and Mihov, 2003; Taylor, 2000; Wyplosz, 2002) except in very exceptional cases (i.e. Feldstein, 2002). Nonetheless, the effects of fiscal policy go beyond macroeconomic stabilization. It can significantly influence the way in which resources are allocated in the long run. Moreover, at least in a democracy, the allocation of resources should ideally reflect society's preferences and priorities. In a way, in a democracy such priorities ought to be determined by democratically elected representatives. To the extent that budget inflexibility impairs the ability of elected representatives to allocate resources, this could be an additional argument in favor of discretion (budget flexibility).

    Another argument for budget inflexibility concerns certain expenditures likely to be overlooked by short-sighted governments, but crucial in the long run for society. Consider, for instance, saving for pensions. Governments can have a higher discount rate than society because they think in terms of their electoral term, while the individuals have a longer planning horizon. The adoption of laws that create inflexibility can be thus understood as a mechanism to isolate this type of expenditures from the time inconsistency problem. From this standpoint, budget inflexibility could be considered optimal. However, several objections could be raised. First, it is possible that some inflexible expenditures are not priorities for society, but rather the result of interest groups capturing" the government budget. On the other hand, even if we are dealing with crucial expenses that should not be subject to political fluctuations, there are unexpected shocks that may justify abandoning a rule, as suggested by the literature on escape clauses discussed above.

    Finally, as shown by some of the recent literature on this topic (see for example Neut and Velasco, 2003), the adoption of rules does not necessarily eliminate the problem of time inconsistency. In fact, it could magnify it when the rules adopted are too stringent and adverse shocks leave no option different to renege on previous "promises". Furthermore, as discussed above, there are political reasons that suggest that the degree of budget inflexibility is indeed likely to be excessive to the extent that, many times, these promises might become


    5"incredible policies".

3. The model: the Tragedy of the Commons and fiscal policymaking

    As noted in the literature review, political incentives and conflicts in the budget process can take many forms: conflict over the distribution of the burden of stabilization, intergenerational conflicts, incentives to please "fiscally illuded" voters, etc. More importantly, the political economy of the budget process often implies that resulting policies are economically "inefficient". In this section, we examine the consequences of budget inflexibility in the context of a model that incorporates perhaps the most basic political problem present in the budget process: the Tragedy of the Commons. Also, even though as discussed in the introduction budget inflexibility can take many forms, we will concentrate in one specific type of inflexibility: "expenditure inflexibility". Of course, this is far from a comprehensive analysis of budget inflexibility since, as we suggested in the previous section, this phenomenon might be closely related to all forms of political conflict present in the budget process. Moreover, the model will not explicitly consider the possible advantages of budget inflexibility. Rather, it will illustrate the additional costs that it might generate when there is an underlying common pool problem in the budget process and budget allocation is determined through a bargaining process in Congress.

    As a starting point, we consider as a benchmark the efficient allocation of publicly provided goods across groups under an utilitarian criteria and show how this efficient allocation is feasible when there is full decentralization of financing and spending. We then turn to the more frequent setting where group-specific goods are financed out of a common pool of tax resources to illustrate the "common pool" problem leading to inefficient government expenditure. To introduce the role of expenditure inflexibility we then move to a model of legislative bargaining where coalitions are formed in order to establish the level of transfers across groups in society. We show that, when compared to the flexibility case, the introduction of inflexibility (understood as the possibility of establishing transfers that cannot be reduced or eliminated in subsequent periods) not only leads to higher levels of aggregate government expenditure, but is also likely to generate an inefficiently high and growing level of expenditure as time goes by.

3.1 Efficient government expenditure

    This section presents a simple model by Persson and Tabellini (2000, chapter 7) which helps us illustrates the Tragedy of the Commons arising from the fact that fiscal policy often finances a set of public goods which benefit private interests from a pool of common resources. Then we extend the model to understand the implications of budget inflexibility.

    The setup of the model is as follows. To capture the conflict between different groups in society, we consider

    ja society inhabited by different groups of individuals, each of size (j1,...,J) . Total population is NJ

    j . Preferences in each group are described by the following utility function: NNj

    jjjwcHg....j1,...,J;; (((;;;;;;H00, H?(0, H?0

    jjg where c is per capita consumption of private goods in group j and denotes per capita consumption of a

    jgpublicly provided good benefitting group j. We can think of both as a good or simply as group-specific

     5In the case of Colombia, there is ample historical evidence of "fiscal dictatorship" by the Executive branch which reneges on constitutionally mandated expenses. In the words of a former deputy director of the National Planning Department, the actual problem of budget inflexibility is the actual flexibilty of inflexible expenditures. This, of course, might reduce inflexibility,

    but entails a problem of lack of credibility in institutions.


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