On the Unintended Consequence of Fiscal Rules: Evidence from Fiscal Expenditures

This paper documents the unintended consequence of fiscal rules in the form of tax expenditures using both theory and data. We first introduce a simple fiscal model where the government has time-inconsistent preferences with a present bias toward public spending in line with Halac and Yared (2014). We then empirically validate the main prediction of the model by providing evidence that the adoption of a binding fiscal rule on public spending leads to an increase in tax expenditures, whereas revenue rules, which do not constrain spending, leave them unaffected. Our findings suggest the existence of a robust "innovation channel" in the fiscal domain—paralleling regulatory capital requirements in banking.