Optimal fiscal policy in the face of oil windfalls and other known unknowns

When a country discovers large new natural resource energy reserves, its citizens are gifted with possibility of financing a great economic transformation. Yet, often, the state which manages the transformation fails to deliver a sufficient high and well timed contribution to the well being of current and future citizens. Is it a lack of depth in financial markets or political impatience to spend that best explains the failure of energy revenues to achieve its potential? I answer this question with a model where both resource revenues and returns to the public sector’s financial and physical assets and its liabilities are uncertain. Calibrating for Colombia, I find that when policymakers discount at 20%, 18pp below the social rate, the welfare cost is equivalent to about a quarter of consumption forever, the net stock of assets is much smaller than it should be and discretionary expenditures are very sensitive to surprise resource revenues. If financial markets are sufficiently underdeveloped, we can generate welfare costs of the same magnitude. But shallow financial markets cannot also explain why there are insufficient net effective assets as seems to be the case in Colombia, nor can they explain a heightened sensitivity to revenues. As political impatience is thus the main culprit, a continued emphasis on fiscal policy arrangements that directly
address the temptation to spend too soon is warranted.

By: Lavan Mahadeva