Theory of Procyclical Fiscal Policy

Abstract

Contrary to conventional wisdom, recent research has demonstrated that in most developing countries, fiscal policy runs procyclically. In this chapter, after we review the conventional Keynesian and Neoclassical views, including the “tax smoothing” hypothesis framed by Barro (J Polit Econ 85:940–971, 1979), we describe the recent theoretical challenges that explain this fiscal procyclicality. These challenges can be categorized into two types: (i) imperfection in international credit markets that prevents developing countries from borrowing in bad times (Aizenman et al. in NBER Working Paper, No. 5558, 1996, J Int Trade Econ Dev 9:367–395, 2000; Riascos and Végh in Procyclical government spending in developing countries: the role of capital market imperfections, 2003), and (ii) political distortion to accelerate fiscal expansion (Tornell and Lane in Am Econ Rev 89:22–46, 1999; Talvi and Végh in J Dev Econ 78:156–190, 2005; Alesina et al. in J Eur Econ Assoc 6:1006–1036, 2008; Ilzetzki in J Dev Econ 96:30–46, 2011). In this chapter, we introduce one work for each of the two strands of research derived from these challenges—that is, Aizenman et al. (NBER Working Paper, No. 5558, 1996, J Int Trade Econ Dev 9:367–395, 2000) and Alesina et al. (J Eur Econ Assoc 6:1006–1036, 2008)—and offer a brief review of other studies. In the end, we conclude that we need to build a new theoretical approach based on our empirical findings in Chap. 1.