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Nonlinear Fiscal Transitions and the Dynamics of Public Expenditure Reform

Diego Vallarino

Abstract

This paper develops a nonlinear theoretical framework to analyze the dynamics of public expenditure reallocation in Uruguay. Motivated by recent debates on fiscal reform and expenditure efficiency, the paper models fiscal adjustment as a dynamic process in which expenditure categories exhibit heterogeneous institutional rigidity and convex adjustment costs. Using the national budget for the 2026-2030 fiscal period as an institutional reference, the paper presents a calibrated illustration of the theoretical framework that captures key features of the structure of public spending, including transfers, the public wage bill, operating expenditures, and public investment. The calibration translates institutional characteristics of the budget into quantitative transition dynamics rather than estimating structural parameters econometrically. The framework allows the evaluation of short-, medium-, and long-run fiscal implications of alternative reform strategies, including administrative restructuring, pension reform, and the gradual reallocation of resources toward human capital and productivity-enhancing investment. In contrast to descriptive expenditure reviews based on static budget comparisons, the model explicitly incorporates nonlinear transition dynamics and institutional frictions. Simulations show that structural expenditure reforms generate significant transitional fiscal costs arising from overlapping institutional systems, labor adjustment frictions, and pension transition liabilities. As a result, fiscal reform produces a J-shaped expenditure trajectory in which total spending initially increases before gradually converging toward a more efficient long-run allocation. These findings highlight the importance of accounting for adjustment costs and transition dynamics when evaluating the feasibility and timing of structural fiscal reforms.

Nonlinear Fiscal Transitions and the Dynamics of Public Expenditure Reform

Abstract

This paper develops a nonlinear theoretical framework to analyze the dynamics of public expenditure reallocation in Uruguay. Motivated by recent debates on fiscal reform and expenditure efficiency, the paper models fiscal adjustment as a dynamic process in which expenditure categories exhibit heterogeneous institutional rigidity and convex adjustment costs. Using the national budget for the 2026-2030 fiscal period as an institutional reference, the paper presents a calibrated illustration of the theoretical framework that captures key features of the structure of public spending, including transfers, the public wage bill, operating expenditures, and public investment. The calibration translates institutional characteristics of the budget into quantitative transition dynamics rather than estimating structural parameters econometrically. The framework allows the evaluation of short-, medium-, and long-run fiscal implications of alternative reform strategies, including administrative restructuring, pension reform, and the gradual reallocation of resources toward human capital and productivity-enhancing investment. In contrast to descriptive expenditure reviews based on static budget comparisons, the model explicitly incorporates nonlinear transition dynamics and institutional frictions. Simulations show that structural expenditure reforms generate significant transitional fiscal costs arising from overlapping institutional systems, labor adjustment frictions, and pension transition liabilities. As a result, fiscal reform produces a J-shaped expenditure trajectory in which total spending initially increases before gradually converging toward a more efficient long-run allocation. These findings highlight the importance of accounting for adjustment costs and transition dynamics when evaluating the feasibility and timing of structural fiscal reforms.
Paper Structure (45 sections, 4 theorems, 51 equations, 5 figures, 8 tables)

This paper contains 45 sections, 4 theorems, 51 equations, 5 figures, 8 tables.

Table of Contents

  1. Introduction
  2. Related Literature
  3. Institutional Structure of Public Expenditure
  4. A canonical decomposition
  5. Rigidity as feasibility constraints
  6. (i) Statutory rigidity.
  7. (ii) Contractual rigidity.
  8. (iii) Project rigidity.
  9. Institutional baseline and effective discretion
  10. A Nonlinear Model of Expenditure Adjustment
  11. Control variables, state variables, and law of motion
  12. Objective function
  13. Nonlinear adjustment costs
  14. First-order conditions and economic interpretation
  15. J-shaped fiscal trajectories as an equilibrium implication
  16. ...and 30 more sections

Key Result

Proposition 4.1

Under the assumptions above and for $\beta\in(0,1)$, the planner's problem admits an optimal sequence of expenditure allocations $\{x_t\}_{t\ge0}$.

Figures (5)

  • Figure 1: Baseline expenditure composition
  • Figure 2: Simulated fiscal transition path
  • Figure 3: Nonlinear adjustment cost function
  • Figure 4: Simulated fiscal transition path
  • Figure 5: Simulated expenditure transition by category

Theorems & Definitions (7)

  • Proposition 4.1: Existence of an optimal fiscal transition
  • proof
  • Proposition 4.2: Gradual expenditure adjustment under institutional rigidity
  • proof
  • Proposition 4.3: J-shaped fiscal transitions
  • proof
  • Corollary 4.1