To avoid exploding government debt, numerical macro models require ‘fiscal reaction rules’.
Present rules impose arbitrary, backward-looking reaction of taxes to deviations of the debt ratio from a target. Arbitrary models may be poor guides to monetary policy. An optimising fiscal policy-maker would look forward, and maximise an objective function. A simple optimising model implies the future tax rate should be constant. I implement the constant-future-tax rule in the IMF’s MULTIMOD model. Simulations show model outcomes’ sensitivity to the choice of fiscal rule. A constant tax rate induces smoother and hence preferable consumption paths to MULTIMOD’s existing rule.

JEL Classification: C63, E17, E62, H21, H63

Key words: Computational techniques, forecasting and simulation, fiscal policy, optimal taxation, government debt

Richard Johnson is an economist at the Federal Reserve Bank of Kansas City. This paper waslargely written while the author was working in the Fiscal Policies Division of the European Central Bank.  The author would like to thank the IMF’s Douglas Laxton, Peter Isard, Hamid Faruqee, Eswar Prasad, and Bart Turtelboom for making their MULTIMOD Mark III model available at www.imf.org/external/np/res/mmod/mark3/index.htm, and for their comments on this paper. The views expressed herein are solely those of the author and do not reflect those of the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Johnson E-mail: richard.johnson@kc.frb.org