Until recently most of the research on public finance and study of the optimal fiscal policy was conducted in idealistic settings where government sets taxes and transfers to maximize a well defined social objective function and commits to follow the optimally chosen policy over time. Although such analysis provides a useful benchmark, it ignores political forces that affect policy making in the real world, such as conflict of interests among political groups, their incentives to change existing policy as they gain or lose political power, and desire to choose policies that favors their constituencies. On the other hand, the political economy literature develops sophisticated models of the behavior of politicians but lags behind the modern developments in macroeconomics and public economics that bring to the forefront incentives of economic agents. An additional limitation of current political economy models is that, in contrast to public and macro- economic work, they often lack the analysis of dynamics of the political process which limits their scope in addressing many important issues in economic policy. The integrated framework that this project develops bridges the gap between the two literatures. In this approach each agent makes economic decisions given current policies while also forming expectations about how those policies might change in future due to changes in political power. At the same time politicians evaluate each policy based on the costs and benefits for their constituencies and how such policies might effect their political standing in the future. The focus of this analysis is both on the development of realistic policy recommendations that can be implemented in the political process, and on understanding how government institutions should be designed to mitigate the political constraints. The primary innovations of this project are, (1) to develop political economy models that make few assumptions about the specific institutional details but focus instead on the key political frictions; (2) to integrate such models with the state of the art models of optimal taxation and social insurance and (3) to expand the scope of the optimal fiscal policy analysis by moving from purely normative exercise to realistic recommendations that take politico-economic process into account. This project is directly relevant for a broad set of issues, including social insurance (health, old-age, and disability) and taxation. It is motivated by the concerns that are frequently raised during policy debates but seldom addressed in academic research. To identify most important policy relevant concerns the project uses not only analytical reasoning but also assembles a dataset on the US state government finance and empirically tests it to identify the most important frictions. The results of the analysis have implications for a wide set of the economic issues such as design of social security, tax code and trade policy.

The CAREER award also funds the establishment of a 'Policy Lab' that will bring together undergraduates, doctoral students, and researchers at MIT and Harvard to address fiscal policy questions using economic analysis. A new doctoral level course with an accompanying new textbook will allow other institutions to incorporate this new approach to public finance into their own graduate training programs.

National Science Foundation (NSF)
Division of Social and Economic Sciences (SES)
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Nancy A. Lutz
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National Bureau of Economic Research Inc
United States
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