Fiscal Risk and the Portfolio of Government Programs

From Sam Hanson, David Scharfstein, and Adi Sunderam:

This paper proposes a new approach to social cost-benefit analysis using a model in which a benevolent government chooses risky projects in the presence of market failures and tax distortions. The government internalizes market failures and therefore perceives project payoffs differently than do individual private actors. This gives it a ìsocial risk managementî motive ñprojects that generate social benefits are attractive, particularly if those benefits are realized in bad economic states. However, because of tax distortions, government financing is costly, creating a fiscal risk management motive. Government projects that require large tax-financed outlays are unattractive, particularly if those outlays tend to occur in bad economic times. At the optimum, the government trades of its social and fiscal risk management motives. Frictions in government financing create interdependence between two otherwise unrelated government projects. As in the theory of portfolio choice, the fiscal risk of a project depends on how its fiscal costs covary with the fiscal costs of the governmentís overall portfolio of projects. This interdependence means that individual projects should not be evaluated in isolation.

About ozidar

I'm an Assistant Professor of Economics at the University of Chicago Booth School of Business and a Faculty Research Fellow at National Bureau of Economic Research. You can follow me on twitter @omzidar.
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