Working Paper | 2016

Fiscal Risk and the Portfolio of Government Programs

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

Abstract

In this paper, we develop a new model for government cost-benefit analysis in the presence of risk. In our model, a benevolent government chooses the scale of a risky project in the presence of two key frictions. First, the government internalizes market failures and therefore perceives project payoffs differently than private households do. This gives the government a "social risk management" motive: projects that ameliorate market failures in bad states when household marginal utility is high are appealing. The second friction is that government financing is costly because of tax distortions. This creates a "fiscal risk management" motive: incremental spending that occurs when total government spending is already high is particularly unattractive. A first key insight is that the government's need to manage fiscal risk frequently limits its capacity for managing social risk. A second key insight is that neither fiscal risk nor social risk can be judged in isolation. Indeed, when considering many potential projects, government cost-benefit analysis acquires the flavor of a portfolio choice problem. We use the model to explore how the relative attractiveness of two technologies for promoting financial stability—bailouts and regulation—varies with the government's fiscal burden and characteristics of the economy.

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, September 2016.