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16 Jun 2006

Fiscal Policy: When Theory Collides with Reality

Vito Tanzi

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During the 1950s, Jan Tinbergen and other prominent economists developed an attractive theoretical way of using fiscal instruments (taxes and public spending) to promote socially-desirable economic objectives, such as stabilisation, income redistribution and more efficient allocation of resources. The theory may well have reflected the institutional arrangements that prevailed at the time in the countries of origin of these economists. For these countries, it could be seen as a perhaps naive but still ‘positive theory’. Of course, the arrangements or institutions prevailing in these countries could be significantly different from those in other countries. This would make the theory less realistic for other countries and less useful in predicting policy outcomes. This paper outlines the basic assumptions implicit in the theory and assesses how applicable they are to what is happening in practice. The paper takes the example of Italy in particular and finds major differences between the theory and the observed reality. In Italy there was no specific policy centre within the government where relevant questions of policy were analysed in detail. There was also much less effective control by the executive over the fiscal instruments than assumed by the theory. Deficiencies in essential information, such as the precise fiscal situation at a specific time, also made the pursuit of fiscal goals more difficult. Two core questions are asked. First, whether the European Commission should expand its role to include the promotion of institutions that economists have argued would improve the pursuit of fiscal policy in member countries. Second, whether the deficit concept now used in the evaluation of the outcome of fiscal policy should not be assessed to make it easier to calculate and less controversial.