Public debt and welfare in a quantitative Schumpeterian growth model with incomplete markets

This paper quantifies the welfare effects of counterfactual public debt policies using an endogenous growth model with incomplete markets. The economy features public debt, Schumpeterian growth, infinitely-lived agents, uninsurable income risk, and discount factor heterogeneity. Two versions of the model are specified, one with households holding equity in the group of innovating firms. The model is calibrated to the U.S. economy to match the degree of wealth inequality, the share of R&D expenditure in GDP, the firms’ exit rate, the average growth rate, and other standard long-run targets. When comparing balanced growth paths, I find large welfare gains in equilibria characterized by governments accumulating public wealth. The result is robust to the mechanism used to generate a highly concentrated wealth (i.e., preference heterogeneity or “superstar” income shocks). Welfare effects decompositions show that level effects and growth effects reinforce each other. The responses of both the intermediate goods and their market conditions are key in explaining the large level effects. The version of the model without equity is computationally easier to solve, allowing to consider transitional dynamics. Taking into account the dynamic adjustment to the new long-run equilibrium, I show that the transitional welfare costs are not large enough to change the sign of the welfare effects stemming from a change in public debt. I find that eliminating public debt would lead to a 0.8% increase in welfare, while moving to a debt/GDP ratio of 100% would entail a welfare loss of 0.5%. A decomposition analysis shows that growth accounts for approximately 50% of the overall welfare effects.     

FINANCIAL MARKET COMPETITION AND ECONOMIC GROWTH: THE IMPORTANCE OF HOW PROFITS ARE RETURNED

If households have finite lives, the effect of imperfect competition in the financial sector on economic growth depends also on how its profits are returned. The return may be exogenous though fiscal transfers to the young and/or the old or endogenous through dividend payments to a subset of old households that have acquired financial sector equity. Returning financial profits to the old, either exogenously or endogenously, unambiguously reduces growth, but through the two respective mechanisms of consumption-smoothing and of encouraging 'unproductive saving'. As the latter is the more powerful, a public pension paid for by taxing financial profits will raise steady-state growth rate. However, the main results are that if profits are returned to the young, growth will be highest with monopolistic finance, if the elasticity of intertemporal substitution is sufficiently low; and, generally, the number of Nash–Cournot financial firms that maximizes growth is increasing in the value of this parameter.     

Relative price shifts,economies of scale and poverty during economic transition1

Economic transition is associated with significant shifts in relative prices between private and public goods. If, as a result, public goods claim a larger share of total expenditures, economies of scale in consumption increase. We show how relative price changes might alter the welfare of different‐sized households in the short run and over time. We illustrate, for a selection of transition economies, that conventional poverty profiles are quite sensitive to assumptions made about economies of scale in consumption. In particular, the common view that large households with many children are poor relative to small households (such as those comprising the elderly) is shown to be highly non‐robust.     

The general equilibrium effects of fiscal policy: Estimates for the Euro area

This paper describes a dynamic stochastic general equilibrium model featuring a fraction of non-Ricardian agents in order to estimate the effects of fiscal policy in the Euro area. The model takes into account distortionary taxation on labor and capital income and on consumption, while expenditures are broken down into purchases of goods and services, compensation of public employees and transfers to households. A newly computed quarterly data set of fiscal variables is used. Our results point to the prevalence of mild Keynesian effects of public expenditures. In particular, although innovations in fiscal policy variables tend to be rather persistent, government purchases of goods and services and compensations for public employees have small and short-lived expansionary effects on private consumption, while innovations in transfers to households show a slightly more sizeable and lasting effect. The effects are more significant on the revenue side: decreases in labor income and consumption tax rates have sizeable effects on consumption and output, while a reduction in capital income tax favors investment and output in the medium run. Finally our estimates suggest that fiscal policy variables contribute little to the cyclical variability of the main macro variables.     

Publicly Provided Private Goods and Redistribution: A General Equilibrium Analysis

Public provision of private goods is examined within a self-selection framework where production depends on labour supply of different households and the level of public provision. It is shown that productivity and wage-structure effects can create a role for public provision, even if preferences are weakly separable between goods and leisure. Public provision of education may offer an intuitively appealing case for the production-side impacts. We also address the reasons for public provision in a dynamic, overlapping generations economy, whereby public provision may affect efficiency and social costs of redistribution of future generations as well.
JEL classification : H 23; H 42     

Transparency and Economic Policy

We provide a two period model of political competition in which voters imperfectly observe the electoral promises made to other voters. Imperfect observability generates an incentive for candidates to offer excessive transfers even if voters are homogeneous and taxation is distortionary. Government spending is larger than in a world of perfect observability. Transfers are partly financed through government debt, and the size of the debt is higher in less transparent political systems. The model provides an explanation of fiscal churning; it also predicts that groups whose transfers are less visible to others receive higher transfers, and that imperfect transparency of transfers may lead to underprovision of public goods. From the policy perspective, the main novelty of our analysis is a separate evaluation of the transparency of spending and the transparency of revenues. We show that the transparency of the political system does not unambiguously improve efficiency: transparency of spending is beneficial, but transparency of revenues can be counterproductive because it endogenously leads to increased wasteful spending.     

Equity and efficiency aspects of the Italian debt reduction

The paper deals with the distributional and efficiency consequences of debt reduction in Italy. A reduction of the deficit from six to three percent of GDP is financed by the so-called Eurotax (introduced temporarily or permanently) combined with an adjustment of consumption taxes or public transfers. The quantitative analysis is based on a dynamic simulation model of the Auerbach-Kotlikoff type, which distinguishes between five lifetime income classes within each age cohort. Our simulation results indicate that debt reduction increases the welfare of future generations between 1 and 2% of lifetime resources and that consumption taxes are preferable to the Eurotax on allocative grounds.     

Targeting public goods to the poor in a segregated economy: An empirical analysis of central mandates in rural India

While local governments are increasingly being vested with control over funds for public goods, concern over the capture of decentralized funds by local elites has led decentralization to be combined with central mandates which require a certain proportion of funds to directly benefit the poor. If local capture is pervasive, however, central mandates may not be effective. Despite the popularity of this combination of decentralization and centralized control, there is little empirical evidence which separately identifies their effect on investment in public goods, and hence assesses the effectiveness of central mandates. This paper provides such evidence, using data collected by the authors for the North Indian state of Punjab, an economy where economic conditions facilitate such an analysis. We find that central mandates are effective, enhancing intra-village equality in expenditure on public goods. This finding informs the debate on the equity effects of centralized versus decentralized programs.     

Public debt in a basic endogenous growth model

We work out the mechanism that makes public debt affect the allocation of resources in the long-run. To do so we analyze an AK growth model with elastic labor supply and a government sector. The government levies a distortionary income tax and issues bonds to finance lump-sum transfers and non-distortionary public spending. We show that the long-run growth rate is the smaller the higher the debt ratio if the government adjusts public spending to fulfill its inter-temporal budget constraint. If the government adjusts lump-sum transfers the public debt ratio does not affect the balanced growth rate.     

Portfolio Implications of an Equity Rain in Australia*

In the next decade Australia will experience a substantial privatization program. This represents a switch away from public debt financing towards public equity financing. In this paper, estimates of the likely effect of the government's privatization program on corporate financing are provided. The main result of an increase in the supply of equities along with a commensurate reduction in the supply of government debt is to cause a significant increase in the relative cost of equity, thereby creating incentives for corporate financiers to emphasize reliance on debt financing relative to equity financing. The estimated effect on the weighted cost of finance in the economy, while positive, is small     

Should the Carbon Price Be the Same in All Countries?

International differences in fuel taxation are huge, and may be justified by different local negative externalities that taxes must correct, as well as by different preferences for public spending. In this context, should a worldwide uniform carbon tax be added to these local taxes to correct the global warming externality? We address this question in a second best framework à la Ramsey, where public goods have to be financed through distortionary taxation and the cost of public funds has to be weighted against the utility of public goods. We show that when lump‐sum transfers between countries are allowed for, the second best tax on the polluting good may be decomposed into three parts: one, country‐specific, dealing with the local negative externality, a second one, country‐specific, dealing with the cost of levying public funds, and a third one, global, dealing with the global externality and which can be interpreted as the carbon price. Our main contribution is to show that the uniformity of the carbon price should still hold in this second best framework. Nevertheless, if lump‐sum transfers between governments are impossible to implement, international differentiation of the carbon price is the only way to take care of equity concerns.     

Optimal Income Taxation and Public Good Provision with Endogenous Interest Groups

This paper studies public goods provision when agents differ in earning abilities as well as preferences. Heterogeneity in skills makes redistribution desirable and generates an equity-efficiency trade-off. If tax revenues are devoted to a public good, this trade-off is affected in such a way that income transfers are less desirable. High-skilled individuals thus have an incentive to exaggerate their preferences for public goods. Analogously, low-skilled individuals lobby against public good provision. A requirement of collective incentive compatibility eliminates these biases. It implies that income transfers are increased whenever a public good is provided and are decreased otherwise.     

Debt monetization,inflation, and the ‘neutral’ interest rate

The main purpose of this study is to explore the potential expansionary effect stemming from the monetization of debt. We develop a simple macroeconomic model with Keynesian features and four sectors: creditor and debtor households, businesses, and the public sector. We show that such expansionary effect stems mainly from the reduction in the financial cost to servicing the public debt. The efficacy of the channel that operates allegedly through the compression of the risk/term premium on securities is found to be ambiguous. Finally, we show that countries that issue their own currency can avert getting stuck in a structural ‘liquidity trap’ provided their central banks are willing to monetize the debt created by a strong enough fiscal expansion.     

Do Islamic banks shift from mark-up to equity financing when their contracting environments are improved?

Islamic banks should share their profits and losses with their customers through equity financing but most of their assets are mark-up financing, which resembles loans. Theoretically, one of the reasons is Islamic banks operate in poor contracting environments where equity financing is very risky. Using fixed-effects models, we examine whether better contracting environments induce Islamic banks to shift from mark-up to equity financing. We find no evidence that contracting environments do, which means debt-like instruments will continue dominating Islamic banks’ assets in the near future.     

Environmental Taxation,Inequality and Engel’s Law: The Double Dividend of Redistribution

Empirical evidence shows that low-income households spend a high share of their income on pollution-intensive goods. This fuels the concern that an environmental tax reform could be regressive. We employ a framework which accounts for the distributional effect of environmental taxes and the recycling of the revenues on both households and firms to quantify changes in the optimal tax structure and the equity impacts of an environmental tax reform. We characterize when an optimal environmental tax reform does not increase inequality, even if the tax system before the reform is optimal from a non-environmental point of view. If the tax system before the reform is calibrated to stylized data—and is thus non-optimal—we find that there is a large scope for inequality reduction, even if the government is restricted in its recycling options.     

Commodity Price Instability and Debt-linking by Developing Countries

Most developing countries borrow in world capital markets. Typically this borrowing is denominated in one of the major currencies and requires periodic servicing. The foreign exchange required to meet the service obligation is often dependent on the export of one or a small number of commodities. This demand usually competes with a number of other claims on export earnings, including both consumption and capital goods imports. This paper investigates the use of commodity-linked borrowing by developing countries. If the interest and/or principal payments on external debt are linked to the price of a country's principal exports, the risk of default can be shifted to better-diversified lenders. The social cost of linking is much smaller than that of other compensating arrangements. In addition, commodity-linked debt may reduce the borrower's direct lending costs. This will depend on the quantity of linked debt supplied and the dispersion of expectations about the future price of the commodity. If the supply is small relative to the demand among investors who expect the commodity price to increase, the resulting reduction in the cost of borrowing may be sufficient to offset the premium for bearing the risk associated with the commodity's future price.     

Income Distribution, Taxation, and the Private Provision of Public Goods

This article investigates the role of taxation when public goods are privately provided. Externalities between consumers via the public good are shown to cause kinks in social indifference curves. As a result, a government restricted to income taxation should engineer enough inequality to ensure there are some non-contributors to the public good. Whether commodity taxation changes this conclusion depends on the extent to which consumers "see through" the government budget constraint. If they can, inequality should still be sought. When they cannot, in contrast to the case of an economy with only private goods, commodity taxation can be used in conjunction with income transfers to achieve the first-best.     

THE BEHAVIOR OF U.S. PUBLIC DEBT AND DEFICITS DURING THE GLOBAL FINANCIAL CRISIS

In this paper we test the sustainability of U.S. public debt for the period 1916–2012 by analyzing how the primary surplus to gross domestic product (GDP) responds to changes in the debt to GDP ratio in a time‐varying parameter model. Further, we determine the stationarity property of the debt/GDP ratio while accommodating possible breaks in the data caused by wars and economic crisis under both the null and alternative hypotheses of an endogenous unit root test. The results show that the U.S. public debt was sustainable until 2005 when the primary surplus to GDP reacted negatively to the debt/income ratio. This is further exacerbated during the global financial crisis when primary surpluses continued to fall with increased debt, thus jeopardizing the sustainability of fiscal policy. While the stationarity test shows that the U.S. fiscal debt/GDP ratio is sustainable, it fails to highlight the risk that its debt policy has been becoming unsustainable in recent years. (JEL H62, E62, C2)     

THE FISCAL POLICY RESPONSE TO PUBLIC DEBT IN DEVELOPING COUNTRIES

Theoretical models on fiscal sustainability hypothesize that indebted governments can lower their current debt by generating future primary surpluses, ceteris paribus. While both developed and developing countries struggle with the issue of debt stabilization, the latter, in particular face heightened sensitivity from creditors, which provides them an impetus to respond more strongly to stabilize their debt. Based on a panel of 53 developing countries, we examine the fiscal response of these countries to changes in their debt‐to‐gross domestic product ratio. We find evidence of a positive relationship between the debt and primary surplus and that countries adjust along both the revenue and expenditure margins at roughly the same rate. (JEL E62, H50, O11)     

Testing Vietnam's public safety net

The paper examines the impact of Vietnam's main welfare programs on moving poor people out of poverty and protecting the non-poor from becoming poor. To explore the role that transfers played in the country's dramatic reduction of poverty in the 1990s, counterfactual consumption levels are estimated allowing for behavioral responses. The findings suggest that transfers helped only a few people escape poverty and protected even fewer from poverty. Hence, the public safety net was largely irrelevant to Vietnam's poverty reduction. A larger and better designed public safety net is crucial for the future. Journal of Comparative Economics 32 (4) (2004) 661–679.