Politically Motivated Fiscal Deficits: Policy Issues in Closed and Open Economies

In this paper we reconsider the trade‐off between rules and discretion in fiscal policy in the presence of politically motivated fiscal deficits. We present a model of political bias in the budget process appropriately developed to allow for tax‐smoothing‐motivated deficits as well as for the consideration of deficit biases in open economies. We find that endowing politically‐biased governments with the ability to respond to economic shocks with deficit finance will not exacerbate the existing biases. In an open economy, the ability to borrow abroad will significantly increase the deficit. However, restrictions to public foreign borrowing will not reduce the political bias as long as the private sector has access to international capital markets at the same terms as the government.