Chile’s Fiscal Rule as Social Insurance

Abstract

We explore the role of fiscal policy over the business cycle from a normative perspective, for a government with a highly volatile and exogenous revenue source. Instead of resorting to Keynesian mechanisms, in our framework fiscal policy plays a role because the government provides transfers to heterogeneous households facing volatile income, albeit with an imperfect transfer technology (a fraction of transfers leak to richer households). We calibrate the model to Chile’s highly volatile government revenues derived from copper, and characterize the optimal fiscal reaction. We quantify the welfare gains vis-à-vis a balanced budget rule, and the degree of adequate fiscal countercyclicality. We also analyze simpler rules, such as the structural balance rule in place in Chile during the last decade, more general linear rules, and linear rules with an escape clause. We find that the optimal rule leads to the same welfare gain as doubling the government’s copper revenues under a balanced budget rule. Chile’s structural balance rule achieves 18% of these gains, while a linear rule with an escape clause achieves 83% of the gains. The degrees of countercyclicality of the optimal rule and the linear rule with an escape clause are similar, and much larger than those of the structural balance rule.