Working Paper | 2014

Fiscal Risk and the Portfolio of Government Programs

by Samuel G. Hanson, David S. Scharfstein and Adi Sunderam

Abstract

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 "social risk management" motive—projects 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 off its social and fiscal risk management motives. Frictions in government financing create interdependence between two otherwise unrelated government projects. The fiscal risk of a project depends on how its fiscal costs covary with the fiscal costs of the government's overall portfolio of projects. This interdependence means that individual projects cannot be evaluated in isolation.

Keywords: Risk Management; Programs; Government and Politics;

Citation:

Hanson, Samuel G., David S. Scharfstein, and Adi Sunderam. "Fiscal Risk and the Portfolio of Government Programs." Working Paper, June 2014.