In this chapter we revisit the role of fiscal policy in macroeconomics, focusing on the government budget constraint and the effects of alternative methods of financing government expenditure, such as taxes and government debt.

We saw in Chapters 2 and 5 that if the government has full access to financial markets and can borrow and lend freely at the market interest rate, the government budget constraint is defined in a way which is similar to the intertemporal budget constraint of a household that has free access to financial markets. It requires that the present value of current and future tax revenue is greater than or equal to the sum of the current stock of govern- ment debt and the present value of current and future primary government expenditure. Primary government expenditure is defined as government expenditure excluding interest payments on government debt, and present values are calculated using market interest rates.

We also saw in Chapter 5 that the budget constraint of a government with an infinite horizon does not prevent it from having debt, or even from increasing the level of its debt. It means, however, that the limit of the present value of government debt, as time tends to infinity, cannot be posi- tive. For example, if the real interest rate is positive, a positive but constant real government debt – which means that the government never repays it – satisfies the government budget constraint. Even if government debt in- creases continuously, the government budget constraint is satisfied to the extent that the real interest rate exceeds the growth rate of real government debt.

When the government budget constraint was introduced in the representative household model, it was shown that, if taxes are lump sum, the only aspect of fiscal policy that matters for the choice of the optimal path of pri- vate consumption is the present value of primary government expenditure. The method of financing primary government expenditure, i.e the breakup between government debt and the path of (non-distortionary) taxes, does not affect the optimal path of consumption of the representative household. This property has become known as Ricardian equivalence between taxes and government debt.

It was also shown that Ricardian equivalence does not apply to overlapping generations models. The stock of government debt affects aggregate savings, as current generations realize that part of the present value of fu- ture taxes required to finance the stock of government debt will be paid by future generations. In overlapping generations models, current generations are not concerned with the welfare of future generations. Thus, current gen- erations treat part of their holdings of the existing stock of government debt as part of their wealth, since it exceeds the present value of their own future taxes. As a result, debt and tax finance are not equivalent in overlapping generations models, and Ricardian equivalence does not hold.

Taxes are rarely lump sum and non-distortionary, as they affect incen- tives for savings, investment and labor supply. We have investigated the effects of distortionary taxation in Chapters 2 and 5, and showed that distortionary taxes have negative effects on both labor supply and capital ac- cumulation. More importantly, Ricardian equivalence breaks down in the case of distortionary taxation.

In this chapter we shall focus on models of the determination of the level of distortionary taxes and government debt. We shall thus endogenize government decisions about the evolution of taxes and debt.

As we saw in Chapter 1, government debt has been rising during wars and recessions in both the United States and the United Kingdom. Furthermore, since the early 1980s government debt has been rising continuously in both countries, and other industrial economies, reversing a trend of falling government debt since the end of World War II. Such trends can be partly explained by the prevalence of distortionary taxation, and the attempts of governments to smooth out these distortions. Additional explanations re- quire theories that focus on distributional and political considerations, which we briefly survey.

In the presence of distortionary taxes, the level of government debt matters. In steady state, higher levels of government debt are associated with higher distortionary tax rates, and therefore with higher negative tax dis- tortions. The same obviously applies to higher primary government purchases. Even in representative household models where, with non distortionary taxes, government purchases and government debt do not affect capital accumulation and the dynamic path of output, distortionary tax- ation results in negative effects on capital accumulation and labor supply. Hence if distortionary taxes have to rise in order to stabilize the government debt to output ratio at a higher level, or in order to finance a higher ratio of government purchases to output, there will be negative effects on steady state per capita income and economic growth.

An additional negative effect of high government debt is the possibillity of a debt crisis.

In the last section of this chapter we analyze the Calvo [1988] model of government debt crisis. This is a model in which the interest rate on government debt depends positively on the expected probability of default and the actual probability of default depends positively on the interest rate on government debt.

In such a model there are multiple equilibria. One equilibrium implies a zero or low probability of default, and a low divergence of the interest rate on government debt from the interest rate on safe assets, and the second equilibrium implies a probability of default equal to unity and a failure of the government to borrow at any interest rate. A third intermediate equilib- rium with a high probability of default exists as well, but it is dynamically unstable. In this model the equilibrium that prevail depends on the expec- tations of investors. What equilibrium will prevail is to a large extent a self-fulfilling expectation or prophecy.

In such a model, small changes in the fundamentals can bring about large equilibrium changes, and move us from one equilibrium to another. This is because even small changes to the fundamentals can cause large changes in expectations.

When default occurs, say because of either a change in the fundamentals or expectations, this is unanticipated. It is a jump from a low probability of default equilibrium to an equilibrium with a unitary probability of default.

Thus, in the presence of distortionary taxes, high public debt implies two types of costs:

First, in models with distortionary taxation, higher government deficits and debts, even if sustainable, result in higher distortionary taxes, lower labor supply and employment, lower capital accumulation and growth, and lower steady state per capita income and consumption.

Second, in models with potential default, higher government deficits and debts result in a higher probability of default, which brings about an increase in interest rates on government debt and increases the likelihood of a debt crisis.

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