Conclusion

In this chapter, we first discussed the intertemporal government budget constraint and analyzed the conditions for government debt sustainability. We also analyzed the dynamic effects of government debt and primary government expenditure in the representative household model of Ramsey and the OLG model of Blanchard and Weil.

In the representative household model without distortionary taxes, fiscal policy has no effects on either the convergence process or the balanced growth path. The only fiscal variable that matters for the path of private consumption is the present value of primary government expenditure, which reduces the present value of private consumption by exactly the same amount. The method of financing primary government expenditure—such as government debt and (nondistortionary) taxes—does not affect private consumption or the adjustment and balanced growth path of all other real variables. This result is known as Ricardian equivalence between lump sum taxes and government debt. Holdings of government bonds by the representative household are not considered as wealth and do not affect household consumption, because the representative household realizes that government bonds will be financed by future taxes of equal present value.

The Ricardian equivalence result does not apply to OLG models. The levels of government debt and primary government expenditure affect both the balanced growth path and the adjustment path. This is because current generations realize that part of the future taxes that will finance primary government expenditure (or interest on the government debt) will be shouldered by future generations. Consequently, both primary government expenditure and government debt lead to a reduction in aggregate savings and to a reduction of steady state capital and private consumption.

We also analyzed the dynamic impact of distortionary taxes, as taxes are rarely nondistortionary. In the representative household and OLG models that we have considered, labor supply is exogenous. Consequently, tax rates on income from employment or constant consumption tax rates do not affect employment and savings. As a result, they do not affect either the adjustment path or the balanced growth path. However, tax rates on capital income or business earnings before interest and depreciation are distortionary. They have negative effects on private savings and investment, the accumulation of capital, and per capita real output and real wages. A dynamic simulation of a calibrated Ramsey model suggests that these effects of capital income taxation may be quantitatively significant.

1. Equation (6.1) is a first-order differential equation with variable coefficients, similar to the asset accumulation equation of the representative household in chapter 4. For how to solve it, see appendix C on ordinary differential equations.

2. The term “Ricardian equivalence” is due to Buchanan [1976] who, commenting on the Barro [1974] paper, pointed out that the possible equivalence between debt and taxes was first raised and highlighted by Ricardo [1817].

3. This property of OLG models was first noted in the model of Diamond [1965]. In fact, as its title highlights, the Diamond paper was primarily about the effects of government debt on capital accumulation and economic growth.

4. We shall delve deeper into the rationale for tax smoothing in chapter 21 on fiscal policy and the determination of government debt.

5. With these parameters for fiscal policy, there is a positive initial government debt, because zero debt would imply a primary deficit.

6. The empirical evidence on the long-run effects of government deficits and debts is generally mixed. But it is not necessarily inconsistent with approximate Ricardian equivalence of the kind implied by OLG models or models with other distortions (such as liquidity constraints). See Bernheim [1987, 1989], Barro [1989], and especially Seater [1993] for surveys of the empirical evidence.