Fiscal Policy Ampli\u85ed Cycles

Emerging markets are characterized by high levels of income volatility. These cycles are accompanied by procyclical \u85scal policies: governments tend to increase spending and reduce taxes during expansions; and the reverse during contractions. What gen-erates this procyclicality and does it exacerbate the cycle in emerging markets? This paper addresses this question. We model a developing economy as one with limited access to \u85nancial markets and where the government plays a redistributive role- favoring the workers over the capital-ists. It does this through the use of linear taxes/subsidies, however it lacks commitment. The absence of state contingent \u85nancial assets generates counter-cyclical taxes. How-ever, when the government can fully commit, it is able to use counter-cyclical taxes to provide insurance without distorting capital investment. On the other hand, when it has limited commitment, the government \u85nds itself forced to distort investment in order to provide insurance. More importantly, this distortion is more likely to take place when the economy is in a recession as compared to when it is booming. Consequently, scal policy ampli\u85es the cycle by distorting capital accumulation and exacerbating downturns. This is consistent with empirical evidence on rising expropriation risk and worsening economic freedom indicators during downturns in emerging markets. 1