Conclusion
In this chapter, we have surveyed the macroeconomic role of fiscal policy. We have seen that in the presence of distortionary taxes, Ricardian equivalence does not hold, and 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 distortions. The same obviously applies to higher primary government purchases. This applies even in representative household models where, if taxes are nondistortionary, government purchases and government debt do not affect capital accumulation and the dynamic path of output. Distortionary taxation results in negative effects on capital accumulation and labor supply. If distortionary taxes have to rise to stabilize the government debt-to-output ratio at a higher level (or 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 models with an endogenous probability of default, the likelihood of a debt crisis is higher if government debts and deficits are high.
Thus, in the presence of distortionary taxes, high public debt implies two types of costs:
1. 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.
2. 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.
1. The term “long and variable lags” is due to Friedman [1961], who introduced it in relation to monetary policy.
2. See, for example, Eggerstsson [2010] and Christiano et al. [2011], who comprehensively investigate fiscal policy at the zero lower bound in the context of new Keynesian models. Krugman [2012] also contains a forceful advocacy of this particular position with respect to the Great Recession of 2008–2009.
3. See Chari and Kehoe [1999] or Kocherlakota [2010] for the details of the derivation of the optimal tax rates.