Spending cuts or tax increases? The composition of fiscal adjustments as a signal

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Abstract

This paper shows that the composition of fiscal adjustments, spending cuts versus tax increases, serves as a signal of the government's degree of collusion with special interests. The politico-economic model of fiscal policies, combining retrospective voting with common-agency-type lobbying, presents undominated separating equilibria and intuitive pooling ones, in both of which fiscal adjustments with sufficiently large spending cuts lead to incumbent reappointment whereas those with only tax increases lead to incumbent defeat. These findings are consistent with the recent empirical evidence of voters behaving as fiscal conservatives. The efficiency-enhancing aspects of the signaling mechanism and the effects of imposing a deficit limit are also analyzed.

Original languageEnglish
Pages (from-to)1441-1469
Number of pages29
JournalEuropean Economic Review
Volume50
Issue number6
DOIs
Publication statusPublished - 2006 Aug 1
Externally publishedYes

Keywords

  • Common agency
  • Composition of fiscal adjustments
  • Deficit limits
  • Retrospective voting

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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