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Fiscal Policy Dynamics with a Public-Debt Guideline

This paper analyzes the implications of a cost of deviating upwards from a public debt/output guideline, such as the 0.6 ratio in the Maastricht Treaty, in the context of a fiscal policymaking model. Given a preannounced timetable for enforcement, the dynamic paths of the tax rate and government spending, which depart from smoothing over time, and the public debt are characterized. The model’s predictions are that the tax rate is high and government spending is low prior to the date of starting enforcement, and that at this date the tax rate begins to decline and government spending begins to increase. The model is used to interpret fiscal evidence during the 1990s from three countries with large public debt: Belgium, Italy and Israel.