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 6 that if the government has 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.

We also saw in chapter 6 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. However, the limit of the present value of government debt, as time tends to infinity, cannot be positive. 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 increases 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 private 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 nondistortionary taxes) does not affect the optimal path of consumption of the representative household.

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

Taxes are rarely lump sum and nondistortionary, as they affect incentives for savings, investment and labor supply. We investigated the effects of distortionary taxation in chapters 2 and 6, and showed that distortionary taxes have negative effects on both labor supply and capital accumulation. More importantly, Ricardian equivalence breaks down in the case of distortionary taxation.

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

As discussed 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 in 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 require 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 distortions. The same obviously applies to higher primary government purchases. In representative household models with nondistortionary taxes, government purchases and government debt do not affect capital accumulation and the dynamic path of output. But distortionary taxation results in negative effects on capital accumulation and labor supply. Hence, 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 possibility of a debt crisis.

In section 21.6, we analyze the Calvo [1988] model of government debt crises. 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.

Such a model has 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. A second equilibrium implies a probability of default equal to unity and an inability of the government to borrow at any interest rate. A third intermediate equilibrium with a high probability of default exists as well, but it is dynamically unstable. In this model, the equilibrium that prevails depends on the expectations 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 a change in the fundamentals or in 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:

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.

21.1