Book Description

Public debt and taxation are central concerns of economic policy, with important implications for growth, equity, and stability. This dissertation consists of three essays that examine different aspects of these issues, using a combination of theoretical and empirical methods.The first chapter asks the question - can fiscal rules act as private investment stimulus policy? Such rules impose constraints on fiscal policy through mandated limits on government borrowings. Using annual balance sheet data from the universe of Indian firms that publicly release their annual balance sheet statements, and by exploiting the staggered adoption of the Fiscal Responsibility and Budget Management (FRBM) Act by the Indian states, I find that a state's fiscal rule adoption leads an average firm located in the state to increase its stock of fixed capital at the end of the next financial year by USD1.59 million (the pre-treatment sample average is USD10.2 million). To understand the mechanism, I introduce fiscal rules into the framework of Chari, Dovis, and Kehoe (2020). Analytically characterizing the equilibrium dynamics of public debt, private investment, and bank deposits in a dynamic model of optimal taxation with fiscal rules and endogenous financial repression, I show that borrowing constraints on the government will stimulate private investment if the government is unable to commit to repay its existing debt. In this case, banks are forced to hold government bonds, and a fiscal rule causes ”crowding-in” of investment and a commensurate decline in government borrowings from such financially repressed banks. Empirical evidence from state-level banking and public finance data provides support for this mechanism. Fiscal rules can be welfare-improving if the welfare loss from less tax-smoothing is dominated by the welfare gains from less crowding-out of valuable private investment.This provides a welfare-based rationale for the adoption of the FRBM Act by the federal and state governments in India, and contributes to the broader policy debate on fiscal restraints.The second chapter focuses on intergovernmental transfers in the form of loans and grants between a central government and state governments in a federal economy, and how political distortions can affect these transfers. I consider a multi-period political agency model where, in each period, a coalition government at the center has complete discretion over the amount of loans and grants it may give to different states, taking state elections that happen between periods into consideration. State incumbents tax their electorate, and exert effort to produce a local public good. The key feature of the model is that retrospective voters can perceive their tax burden, but can not observe center-state fiscal transfers. The main theoretical result is that the interaction between the extent of alignment of a state with the center, and how swing the state is in elections, affects the fraction of total transfers it receives in the form of loans, with this ratio being a decreasing function of the interactive term. Predictions from the model are tested using novel data from the Indian states over the period 1991-2019, and estimates suggest that an aligned state which is one standard deviation below the average aligned state in terms of the extent of alignment (as measured by the fraction of central cabinet portfolios held by the leading party in the state), and has the same degree of swing-ness (as measured by the fraction of seats assigned to the state in the national legislature that is controlled by the leading party at the center) as the average aligned state, has a 5.44% larger loans to total transfers ratio.Finally, in the third chapter (coauthored with Parimal Bag and Peng Wang), we examine how neighborhood information alters equilibrium auditing policy in tax enforcement. There is increasing reliance on data-driven auditing of businesses and proprietorship. However, the tax returns have garbled signals that are further confounded due to underreporting. We consider a model where entrepreneurs' profits depend on their individual types and a common market shock. A low ability, high profit earner underreports only when she observes her neighbor to have earned low profits: neighborhood information about the performance of other entrepreneurs in the same business prompts such strategic reporting, making the volume statistic of 'high submissions' a meaningful indicator of the market shock. In response auditors scrutinize all low profit returns only if the proportion of high submissions exceeds a threshold cutoff. Because this cutoff is endogenous and depends on the stochastic types and market shock, tax returns cannot systematically avoid audit scrutiny as in exogenous cutoff tax returns models. Auditing is enriched to combat the high 'tax gap', a well-known problem in tax enforcement.