Fiscal Policy in Dynamic Economies

Kim Heng Tan

• Publisher: Taylor & Francis
• Year: 2016
• Print ISBN: 9780415603157
• eBook ISBN: 9781134870127
• Edition: 1
• Topic: Economia
• Subtopic: Teoria economica

The role of fiscal policy in short-run macroeconomic stabilization is, by now, well known in the academic literature and in policy circles. However, this focus on the short-run, especially in a democracy, means that much less attention has been paid to the other consequences of the use of fiscal policy. By studying the intergenerational-welfare aspects of fiscal policy, this book deals with some fundamental issues of fiscal policy. Why does public debt tend to rise over time in democracies? Why is there a tendency for government spending on consumption and on social security to grow? Why do governments fail to invest in public capital adequately? Should a dollar transferred from the young be treated as a dollar transferred to the old? By studying the international aspects of fiscal policy, the book establishes international differences in fiscal policy as determinants of persistent trade imbalances and international indebtedness. It also considers some basic questions on international transfers and austerity in open economies. What criteria should be used to define a successful foreign-aid programme? Why is foreign aid likely to fail in a world of global wealth disparity? Can reliance be placed on the international coordination of austerity to improve welfare in the long run? Is austerity accompanied by international transfers superior to austerity unaccompanied by international transfers?

This book based on the OLG model fills a gap on fiscal-policy issues in the recent spate of books on overlapping generations.

1
Introduction

In modern economies, governments have come to play an ever-increasing role in the allocation and distribution of society’s resources. Government action through spending on the provision of public goods confers benefits on the private sector by improving the wellbeing of consumers. Government spending on public capital such as public infrastructure confers benefits on the private sector by enhancing the productivity of producers. By conferring benefits on the private sector through public consumption and public investment, governments can reallocate resources by changing the composition of private spending relative to public spending in final output. Government action through taxation and borrowing extracts resources from the private sector, while subsidies/transfers transfer resources to the private sector. By extracting resources from and transferring resources to the private sector, governments redistribute income within the private sector that can increase or decrease income inequality. Whether resources are reallocated or redistributed by government spending, taxation and borrowing, such policy actions impinge on savings and capital accumulation and, in turn, affect output, employment, prices and other economic variables. By affecting output, employment and prices, the policy actions can influence the stabilisation of the macro-economy. In the terminology of Musgrave (1959), governments through their policy actions perform the roles of the allocation and distribution of resources as well as the stabilisation of the macro-economy.

The government actions of spending, taxation and borrowing are, collectively, termed fiscal policy in this book. By a fiscal policy instrument, we refer to the individual policy action such as government spending in the form of public consumption or public investment, taxation in the form of labour-income taxation or capital-income taxation, transfers in the form of social security to the old, government borrowing, and so on.

This book is about fiscal policy in dynamic economies. We study the effects of exogenous increases in the fiscal-policy instrument of interest as well as its optimal provision. Since the effects of fiscal policy are felt not only intertemporally, but also internationally, both dimensions of fiscal policy are considered with the intergenerational effects being studied in the first part of the book and the international effects in the second part.

Following the formulation of a dynamic model for a closed economy in Chapter 2 and a study of equilibrium analysis in Chapter 3, we commence with a study of public debt in Chapter 4. We study the intergenerational redistribution of welfare due to public debt in financing tax cuts, government consumption and social security. In each case, we find that increasing public debt redistributes welfare from future generations to the present generation simply because future generations will have to pay for retiring and servicing the debt. Why is this intergenerational redistribution of welfare of interest? The reason is that it provides a simple basis to understand why public debt is used so frequently as a source of finance and why it rises over time in capitalist democracies subject to the electoral cycle.

In Chapter 5, we study the intergenerational incidence of government consumption as well as the optimal provision of government consumption. It is usual in the literature in such studies to assume that government spending does not affect private consumption. We relax this assumption by allowing for the possibility that government spending may affect the intertemporal allocation of consumption. In studying the intergenerational incidence of government consumption, we are interested ultimately in how the time path of welfare of consumers is affected by government consumption. Government consumption redistributes welfare intergenerationally by affecting the time paths of the interest rate and wage rate as well as conferring utility directly on consumers. We show how the intergenerational distribution of welfare due to government consumption is affected by the degree of substitutability between public and private consumption.

To gain insight into how the welfare of different generations is affected by government consumption, we consider optimal public-good provision and revisit Samuelson’s (1954) condition that optimal provision requires the sum of the marginal rates of substitution (MRS) between the public good and a private good to be equal to the marginal rate of transformation (MRT). We show that Samuelson’s condition, which holds true for an economy without distortions, has to be modified to include a cost of the distortion arising from the economy not being at the optimal or golden-rule value of the capital stock. This cost, which may be interpreted as a dynamic cost in contrast to the static cost of financing the public good, is affected by the state of the economy relative to the golden rule as well as by the degree of substitutability between public and private consumption. What is most interesting in our study of optimal provision is to show that the marginal social cost of public-good provision for generation 1 is lower than that for all future generations including those in the long run. The implication of this is that any incoming government due to a change of political parties in power will not commit to the levels of government spending according to the long-run policy on optimal public consumption and will instead opt for optimal government spending as prescribed for generation 1. The reason for this is that, as the marginal social cost is lower for generation 1, more government spending can be committed to and more votes can be garnered from the electorate to stay in power. Consequently, politicians vying for political power in capitalist democracies tend to favour government spending on consumption with the result that public-consumption levels tend to exceed the optimal amount prescribed for the long run.

We study a number of issues related to public capital in Chapter 6. The first issue is the basic one of the consequences for the macro-economy when public infrastructure is unexpectedly destroyed. This issue has become more relevant in recent years as a result of the increasing frequency of natural disasters. The second issue is concerned with how public capital affects welfare intergenerationally. Studying the intergenerational incidence of public capital through a better understanding of how the costs and benefits of public capital are shared intergenerationally helps policy makers make better decisions in implementing infrastructure projects. To provide more insight into how welfare is affected by public capital, we consider optimal public investment and revisit Kaizuka’s (1965) condition that optimal public-capital provision requires the sum of the marginal product of public capital to producers to be equal to the marginal cost of public capital. However, Kaizuka’s condition is concerned with productive efficiency, whereas the optimal level of public capital we are seeking is concerned with economic efficiency. A key finding from our study of optimal public investment is that the marginal benefit in the short run is less than that in the long run as it takes time to build public capital and to enjoy the productivity gains. This finding implies that spending on public capital is not a vote-enhancing policy instrument unlike other forms of government spending. Consequently, some democracies may fail to invest adequately in public capital.

We study social security in Chapter 7. The incidence of social security is concerned ultimately with the intergenerational distribution of welfare due to social security. To gain insight into how welfare is affected by old-age transfers, we consider the optimal provision of old-age transfers funded by labour-income taxes, the so-called pay-as-you-go system of social security. In studying the optimal provision of social security, we find that the marginal social cost facing the first generation is less than that for all future generations. This finding implies that, like government spending on consumption, spending on social security is favoured by politicians vying for political office and tends to be larger than the optimal amount prescribed for the long run. We also find that, in the optimal provision of social security, the marginal utility of a dollar transferred from the young is not equal to that of a dollar transferred to the old away from the golden rule. This finding, arising from the diminishing marginal utility of income, emerges from our analysis based on efficiency considerations, and is not imposed as a value judgement. The significance of this finding is that, where transfers have to be optimally effected away from the golden rule, not recognising that ‘a dollar is not a dollar’ can lead to sub-optimal outcomes for public policy.

When fiscal policy is considered in open economies, fiscal policy can encompass more policy instruments such as export and import taxes, taxes on foreign-investment income and international transfers. As these policy instruments are usually studied in international trade, they will be ignored in this book with the exception of international transfers. We incorporate international transfers into the government budget and treat international transfers as a fiscal-policy instrument for the reason that we will be studying austerity in open economies, and that a pertinent question to ask is whether achieving welfare improvement in the international coordination of austerity in open economies depends on international transfers.

Following Chapter 8’s model formulation for open economies, we commence our study of the international aspects of fiscal policy in Chapter 9 by examining the positive and normative implications of international differences in fiscal policy. We revisit Gale’s (1971, 1974) trade-imbalance story that persistent imbalances in trade and current accounts are driven by international differences in technology or taste by asking: given that nations typically differ in fiscal policy in terms of differences in the levels of government spending, taxation and borrowing, can international differences in fiscal policy lead to persistent imbalances in international indebtedness and trade? If so, this would be paradoxical for two reasons. First, it seems infeasible in a budgetary sense that any nation could be in perpetual debt to another nation. Second, it seems inefficient that any nation would be a perpetual net exporter of goods when the net exports could have been consumed. A related but normative issue is how international differences in fiscal policy affect the intergenerational distribution of welfare for nations under international trade relative to autarky.

As a prelude to studying austerity in open economies, we study international transfers in Chapter 10. We ask some basic questions on foreign aid. What criteria should be used to define a successful aid programme? What should policy makers look for in designing a successful foreign-aid programme? Seeking solutions to these questions is important in determining whether and when to extend foreign aid. Unfortunately, in seeking solutions to these questions, we arrive at a dismal conclusion: foreign aid is likely to fail in a world of global wealth disparity.

Finally, we consider the issue of austerity in open economies in Chapter 11. The effects of austerity in open economies are not the same as those in a closed economy. Whereas a closed economy can improve its welfare in the long run by cutting public debt (Diamond, 1965), welfare improvement is not guaranteed if an open economy undergoes austerity unilaterally (Persson, 1985). If a nation cannot rely on cutting public debt unilaterally to attain long-run welfare improvement, can reliance be placed on the international coordination of austerity (at least among a group of economies) to achieve Pareto improvement in the long run? This issue is of relevance to economies, such as the Eurozone countries, that have been engaged in austerity in the wake of the Eurozone debt crisis. In a fiscal union, such as the United States, a transfer to the poorer member states would have helped these states under austerity situations. For countries that are not a fiscal union, like the Eurozone, we take up the issue of whether austerity accompanied by international transfers from the richer nations to the peripheral nations is superior to austerity unaccompanied by international transfers.

The issues addressed in this book are studied within a dynamic general-equilibrium (DGE) framework using Diamond’s (1965) version of the overlapping-generations (OLG) model due to Samuelson (1958). In this model, consumers form overlapping generations and live for two periods. They work and save in the first period, and retire and consume their savings in the second period. Producers produce a single good using labour and private capital rented from consumers and public capital supplied by the government. The government taxes labour and capital income and borrow to spend on a public good and public capital and to provide pensions to the old. Extended to the open-economy context, governments are also engaged in international transfers under perfect capital mobility and international trade.

We employ the OLG model rather than the Ramsey (1928) model that is currently in vogue in Macroeconomics for the simple reason that a large part of this book is devoted to studying the intergenerational redistribution of welfare, for which the Ramsey model is ill-suited to the task as it employs a representative consumer that lives forever. On the other hand, the OLG model captures the finite life-span of consumers and is the appropriate medium to use for analysing the intergenerational distribution of welfare.

The OLG model that is employed in this book possesses two distinctive features. First, it is fairly general and unified, containing a set of varied fiscal-policy instruments that includes government consumption, public investment, public debt, taxation of labour income and capital income, and social security to the old. Extended to the open-economy context, the set of fiscal-policy instruments includes international transfers. Second, the model in this book adopts consistently a dual approach throughout and contrasts with the semi-duality approach of other dynamic models in much of the literature. In the duality approach as opposed to the primal approach, functions are expressed in terms of prices rather than in terms of quantities. The duality approach yields results in a simple and intuitive manner.

The formulation of the OLG model and its solution in differential comparative-statics form are taken up in Chapter 2 for a closed economy and in Chapter 8 for open economies. The solution of the model in differential comparative-statics form will be required for the short-run and long-run analyses of the issues to be addressed in this book. Equilibrium analysis of the model solution for a closed economy is examined in Chapter 3. Equilibrium analysis is concerned with the investigation of the conditions under which choices of economic agents are made compatible in the sense that supply equals demand in every market. The usual questions on the existence, uniqueness...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• Preface
• Acknowledgements
• 1 Introduction
• 2 Modelling a closed economy
• 3 Equilibrium analysis
• 4 Public debt
• 5 Government consumption
• 6 Public investment
• 7 Social security
• 8 Modelling open economies
• 9 The trade imbalance story
• 10 Welfare economics of foreign aid
• 11 Welfare economics of austerity in open economies
• 12 Conclusion
• Index