Nonlinear Fiscal Transitions and the Dynamics of Public Expenditure Reform

TL;DR

This paper presents a nonlinear theoretical model to analyze public expenditure reforms, emphasizing transition dynamics, institutional frictions, and fiscal costs, with an application to Uruguay's fiscal policy planning.

Contribution

It introduces a calibrated nonlinear framework capturing transition costs and institutional rigidity in fiscal reforms, providing dynamic insights beyond static budget analysis.

Findings

Reforms cause initial expenditure increases due to transition costs.

Structural reforms follow a J-shaped expenditure trajectory.

Transition dynamics significantly impact reform feasibility and timing.

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.