Risk Assessment Under a Non-linear Fiscal Rule.

In the aftermath of the recent financial crisis and recession, governments' actions around the world suggest a non-linear responsiveness of fiscal policy to debt. Additionally, governments are realizing that they face fiscal limits on the size of debt that they can repay. The fiscal limits arise due to distortionary taxation and political will. This paper explores the implications of a non-linear fiscal rule coupled with fiscal limits on solvency crisis. We derive the restrictions on the non-linear fiscal rule necessary to eliminate explosive behavior. We show that the marginal response of primary surplus to debt should be larger than the interest rate times an adjustment factor for the persistence in the primary surplus. However, a non-linear fiscal rule which eliminates explosive behavior can still experience a solvency crisis because of stochastic shocks. We derive the dynamics in the run-up to a solvency crisis and find that a non-linear fiscal rule can reduce the probability of solvency crisis.