Fiscal Risk and the Portfolio of Government Programs

40 Pages Posted: 24 Oct 2016 Last revised: 14 Mar 2021

See all articles by Samuel Gregory Hanson

Samuel Gregory Hanson

Harvard University - Business School (HBS)

David S. Scharfstein

Harvard Business School - Finance Unit; National Bureau of Economic Research (NBER)

Aditya Sunderam

Harvard University

Date Written: October 2016

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, there are market failures, which cause the government to perceive project payoffs differently than private households do. This gives the government a "social risk management" motive: projects that ameliorate market failures 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 fiscal risk and social risk interact in complex ways. When considering many potential projects, government cost-benefit analysis thus 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.

Suggested Citation

Hanson, Samuel Gregory and Scharfstein, David S. and Sunderam, Aditya, Fiscal Risk and the Portfolio of Government Programs (October 2016). NBER Working Paper No. w22763, Available at SSRN: https://ssrn.com/abstract=2858093

Samuel Gregory Hanson (Contact Author)

Harvard University - Business School (HBS) ( email )

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David S. Scharfstein

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
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HOME PAGE: http://www.people.hbs.edu/dscharfstein/

National Bureau of Economic Research (NBER)

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Aditya Sunderam

Harvard University ( email )

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