Inflating the beast

the long version

High commodity prices and a sustained global expansion have brought about a new policy dilemma for many economies: Why are governments accumulating so much wealth and what should be the fiscal response to this abundance? In this paper we characterize how politicians' rent-seeking incentives and their interaction with political and economic uncertainty affect the management of abundance. In the standard political economy model of debt, the presence of political risk leads current governments to over-borrow in order to starve the beast. However, when economic risk is significant, we show that the presence of rent-seeking politicians gives rise to an option value of rent-seeking. In this case, if economic risk is large relative to political risk, the standard result is overturned and politicians have an incentive to over-save or inflate the beast. In the latter scenario, the government also hedges less than is socially optimal. Finally, we show that incentive compatible rules that weaken political risk and the option value of rent-seeking can improve social welfare One implementation of such rules takes the form of contingent tax caps (lower during booms). In contrast, standard fiscal rules are suboptimal since they do not address the central problem of high taxes. Keywords: Public funds, politicians, retained rents, starve the beast, inflate the beast, option value of rent-seeking, commitment, hedging, fiscal rules, tax-caps. JEL Classifications: E6, H2, H6.