Essays on Fiscal Policy in Developing Countries

Abstract

Several empirical studies have found that government expenditures are procyclical in developing countries, unlike the countercyclical expenditures observed in high-income countries. This dissertation attempts to explain this phenomenon and to refine this empirical observation. It contains two essays. The first provides a dynamic political economy theory of the phenomenon of procyclical fiscal policy. In the model, governments provide public insurance to uninsured households, and time-consistent redistributive policies are countercyclical. The introduction of a political friction, in which alternating governments disagree on the desired redistributive policy, can lead to procyclical transfer policies. In numerical simulations, the model successfully captures the cyclicality of government expenditures, tax revenues, and deficits observed in the data for both high-income and developing countries. Simulations also allow a quantitative comparison with other common explanations for fiscal procyclicality. Without the political friction, borrowing constraints and differences in macroeconomic volatility cannot account for the differences in fiscal policy across countries in this setting.

The second chapter addresses potential endogeneity problems in the measurement of the fiscal stance. We build a novel quarterly dataset for 49 countries covering the period 1960-2006 and subject the data to a battery of econometric tests: instrumental variables, simultaneous equations, and time-series methods. We find that (i) fiscal policy is indeed procyclical in developing countries and (ii) fiscal policy is also expansionary, lending empirical support to the notion that "when it rains, it pours."