Debt and deficit ceilings, and sustainability of fiscal policies: An intertemporal analysis

In this paper we examine the likely consequences for the sustainability of fiscal policy of pursuing goals that rely on restictive ceilings on deficit s and debt. We provide a formal theoretical framework for analyzing the sus tainability of fiscal policy based on the government intertemporal budget c onstraint and derive conditions that determine whether a given fiscal stanc e is sustainable. This framework generalizes the existing literature in sev eral important respects. We allow for time-varying interest rates, for feed back from debt to the primary deficit, for a finite planning horizon suitab le for medium-term policy making, for possible future policy shifts, we sho w how published forecasts can be used and we provide a measure of fiscal pr essure. We then apply this analysis to the fiscal positions of the United S tates and the European Union countries since 1970 and to their planned posi tions over the next decade. We find that many countries do not have a sustainable policy. The evidence in favour of sustainablitly is strengthened for most countries when the dat a are extended to incorporate future fiscal consolidation plans, reflecting the general shift toward fiscal austerity in recent years. In contrast, wi th a finite horizon we show that the recent policy shift made the paths of future policies sustainable. However, imposing ceilings on debt or deficit- to-GDP ratios throws most economies onto an intertemporally inconsistent pa th unless governments undertake a major tax or expenditure adjustment. High -debt countries can satisfy debt rules only by raising (reducing) the avera ge tax (spending) rate substantially for five years. A deficit ceiling puts an increasingly high pressure on most economies, including the United Stat es, requiring a gradual rise (decline) in the tax (spending) rate. We concl ude therefore that imposing debt or deficit ceilings could lead to fiscal p olicy becoming a difficult political choice.