Assessing the effect of uncertainty in policy decisions on the sustainability of the Stability and Growth Pact: A functional analysis approach

We model the Stability and Growth Pact (SGP) efficiency criterion for managing tax revenues within a stochastic optimal control problem and analyze the role of uncertainty stemming from unexpected public expenditure. We employ a functional analysis approach based on the Riccati equation, specifically tailored for this stochastic setting, and assess the stability properties of the model. We have the following results: (i) the optimal tax revenue is a nonstationary process in a long-run cointegration equilibrium with long-term public debt, which is a nonstationary process, too; (ii) the long-run equilibrium is not viable during a prolonged downturn of the economic cycle; (iii) a monetary policy responding to fiscal shocks may postpone the noncompliance with the SGP; (iv) the probability of noncompliance with the SGP based on a logistic regression model is increasing with the extent of political uncertainty, and declines as the upper limit for the socially sustainable average tax rate rises. Our analysis shows that structural reforms should be directed to mitigate the cost of uncertainty in public expenditure and improve the quality of public services.