Proceedings from the ECFIN Workshop "The budgetary implications of structural reforms" - Brussels, 2 December 2005

Note that the particular choice of instrument θ₁ has no implications for the
optimal policy choice. It is obvious that it in general cannot be optimal to let
one policy parameter to carry the burden of adjustment. The interpretation
is thus that by focusing on one policy instrument one provides perspective on
the direction and order of magnitude of the needed policy changes, and one
policy instrument is singled out only for simplicity. For this to be useful the
instrument θ₁ chosen needs to be a general policy instrument which is easily
controllable. For instance a tax rate with a broad tax base. In practice a
combination of policy instruments will be used, and the requirement is that
the package achieves a total effect corresponding to the effect captured by the
difference between θ₁^payg (t) and θ1 (0).

This approach is relatively simple to apply but it has two main disadvan-
tages. First, it implies that the initial debt level is kept constant throughout
time. This leaves aside whether this is optimal. Second, requiring a period-by-
period balancing of the public budget is unnecessarily restrictive and implies
that the capital market is not allowed to be used to smooth the adjustment.

Sustainable policies

An alternative procedure is to solve for the permanent level to which θ1 would
have to be adjusted for the intertemporal budget constraint (5) to be satisfied
- allowing all policy functions and all other policy parameters to be unchanged
and thus time invariant¹⁰. Denote this value by θ1. The interpretation is thus
that by making an adjustment of the policy parameter θ₁to θ₁, the total policy
package is sustainable in the sense that it is consistent with the intertemporal
budget constraint. By implication future policy changes are only needed to
deal with unanticipated changes. The case of sustainable policies can also be
interpreted as smooth policies in the sense of time invariant policies. It is often
a policy objective to avoid policy changes and having policies invariant over
time and thus generations. There can also be efficiency arguments for choosing
smooth tax policies (Barro(1979)).

By comparing the current value of the policy instrument θ1 to the sustainable
value θ 1 one can assert both the sustainability of current policies and the needed
order of adjustment to ensure sustainability. Specifically we have that current
policies violate (14) and therefore are unsustainable, that is, the present value
of revenues falls short of the present value of expenditures including initial debt
if

∂b

θι > θɪ   for ∂θ1 > 0

∂b

θι < θι   for dθɪ < 0

The interpretation is that if the instrument θ1 chosen is a revenue instrument
( ∂∂θbl > 0) then there is a sustainability problem if the sustainable value exceeds

¹⁰ Presuming that a solution exists, cf also appendix.

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