Optimal Policy Reforms

This paper develops a general framework to construct optimal policy reforms starting from a status quo set of policies. We show that if a policymaker can control how fiscal externalities are spent, then the welfare-weighted marginal value of public funds (WMVPF) is the relevant sufficient statistic for determining optimal policy reforms. If a policymaker cannot control how fiscal externalities are spent, then the welfare-weighted net social benefit (WNSB) is the relevant sufficient statistic. If a policymaker can control how a fraction of fiscal externalities are spent, then the relevant sufficient statistic is an “internal WMVPF” plus an “external correction” term. We provide a number of stylized examples to illustrate when in practice to use the WMVPF vs. the WNSB to determine optimal policy reforms.