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krueger - dynamic fiscal policy

Apr 16, 2015

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bengi-han

dynamic fiscal policy

Dynamic Fiscal PolicyDirk Krueger1 January 28, 2005

1 I would like to thank Victor Rios Rull, Jesus Fernandez Villaverde and Philip Jung c for many helpful discussions. by Dirk Krueger

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ContentsPreface ix

I

Introduction

15 5 12 19

1 Empirical Facts of Government Economic Activity 1.1 The Size of Government in the Economy . . . . . . . . . . . . . . 1.2 The Structure of Government Budgets . . . . . . . . . . . . . . . 1.3 Government Decits and Government Debt . . . . . . . . . . . .

II

Dynamic Consumption Choices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2527 27 29 34 34 35 39 43 45 47 47 50 51 53 54

2 A Two Period Benchmark Mo del 2.1 The Model . . . . . . . . . . . . 2.2 Solution of the Model . . . . . . 2.3 Comparative Statics . . . . . . . 2.3.1 Income Changes . . . . . 2.3.2 Interest Rate Changes . . 2.4 Borrowing Constraints . . . . . .

3 The Life Cycle Model 3.1 Solution of the General Problem . 3.2 Important Special Cases . . . . . . 1 3.2.1 Equality of = 1+r . . . . 3.2.2 Two Periods and log-Utility 3.2.3 The Relation between and 3.3 Empirical Evidence . . . . . . . . . 3.4 Potential Explanations . . . . . . .

. . . . . . . . 1 and 1+ r . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumption Growth . . . . . . . . . . . . . . . . . . . . . . . .

III

Positive Theory of Government Activity

5961 62

4 Dynamic Theory of Taxation 4.1 The Government Budget Constraint . . . . . . . . . . . . . . . . iii

iv 4.2 The Timing of Taxes: Ricardian Equivalence . . . . 4.2.1 Historical Origin . . . . . . . . . . . . . . . . 4.2.2 Derivation of Ricardian Equivalence . . . . . 4.2.3 Discussion of the Crucial Assumptions . . . . Consumption, Labor and Capital Income Taxation . 4.3.1 Income Taxation . . . . . . . . . . . . . . . . 4.3.2 Theoretical Analysis of Consumption Taxes, come Taxes and Capital Income Taxes . . . .

CONTENTS . . . . . . . . . . . . . . . . . . . . . . . . Labor . . . . . . . . . . . . . . . . . . . . . . . . . . . In. . . . . . . . . . . . . . . . . . 64 64 65 68 73 73 80 93 93 95 95 97 98 101 101 104 104 104 108

4.3

5 Unfunded Social Security Systems 5.1 History of the German Social Security System . . . . . . . 5.2 Theoretical Analysis . . . . . . . . . . . . . . . . . . . . . 5.2.1 Pay-As-You-Go Social Security and Savings Rates 5.2.2 Welfare Consequences of Social Security . . . . . . 5.2.3 The Insurance Aspect of a Social Security System

6 Social Insurance 6.1 International Comparisons of Unemployment and Unemployment Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.2 Social Insurance: Theory . . . . . . . . . . . . . . . . . . . . . . 6.2.1 A Simple Intertemporal Insurance Model . . . . . . . . . 6.2.2 Solution without Government Policy . . . . . . . . . . . . 6.2.3 Public Unemployment Insurance . . . . . . . . . . . . . .

List of Figures1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 2.1 2.2 2.3 2.4 3.1 3.2 US Trade Balance, 1967-2001 . . . . . . . . . . . . . . . . . . . . Government Spending, Fraction of GDP . . . . . . . . . . . . . . Net Exports for (West) Germany, Constant Prices . . . . . . . . Government Consumption as a Fraction of GDP for (West) Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Government Investment as a Fraction of GDP for (West) Germany US Government Debt . . . . . . . . . . . . . . . . . . . . . . . . US Debt-GDP Ratio . . . . . . . . . . . . . . . . . . . . . . . . . German Debt-GDP Ratio . . . . . . . . . . . . . . . . . . . . . . Optimal Consumption Choice . . A Change in Income . . . . . . . An Increase in the Interest Rate Borrowing Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 11 13 14 15 21 22 24 33 36 38 41 51 54

Life Cycle Proles, Model . . . . . . . . . . . . . . . . . . . . . . Consumption over the Life Cycle . . . . . . . . . . . . . . . . . .

v

vi

LIST OF FIGURES

List of Tables1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 2.1 4.1 4.2 4.3 4.4 4.5 6.1 6.2 6.3 Components of GDP for the US, 2001 . . . . . . . . . Components of GDP for Germany, 2001 . . . . . . . . Consolidated Government Budget for Germany, 2002 . German Federal Government Budget, 2002 . . . . . . Federal Government Budget, 2002 . . . . . . . . . . . State and Local Budgets, 2002 . . . . . . . . . . . . . Federal Government Decits as fraction of GDP, 2003 Government Debt as Fraction of GDP, 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 12 16 16 17 18 19 23 37 62 87 88 90 90

Eects of Interest Rate Changes on Consumption . . . . . . . . . Consolidated Government Budget for Germany, Labor Supply, Productivity and GDP, 1993-96 Labor Supply, Productivity and GDP, 1970-74 Actual and Predicted Labor Supply, 1993-96 . . Actual and Predicted Labor Supply, 1970-74 . . 2002 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Unemployment Rates, OECD . . . . . . . . . . . . . . . . . . . . 102 Long-Term Unemployment by Age, OECD . . . . . . . . . . . . . 102 Unemployment Benet Replacement Rates . . . . . . . . . . . . 103

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viii

LIST OF TABLES

PrefaceIn these notes we study scal policy in dynamic economic models in which households are rational, forward looking decision units. The government (that is, the federal, state and local governments) aect private decisions of individual households in a number of dierent ways. Households that work pay income and social security payroll taxes. Income from nancial assets is in general subject to taxes as well. Unemployed workers receive temporary transfers from the government in the form of unemployment insurance benets, and possibly welfare payments thereafter. When retired, most households are entitled to social security benets and health care assistance in the form of medicare. The presence of all these programs may alter private decisions, thus aect aggregate consumption, saving and thus current and future economic activity. In addition, the government is an important independent player in the macro economy, purchasing a signicant fraction of Gross Domestic Product (GDP) on its own, and absorbing a signicant fraction of private (and international saving) for the nance of its budget decit. We attempt to analyze these issues in a unied theoretical framework, at the base of which lies a simple intertemporal decision problem of private households. We then introduce, step by step, scal policies like the ones mentioned above to analytically derive the eects of government activity on the private sector. Consequently these notes are organized in the following way. In the rst part we rst give an overview over the empirical facts concerning government economic activity in industrialized countries and then develop the simple intertemporal consumption choice model. First, we will x some ideas in a simple two-period model, before developing the general permanent income/life cycle model of Friedman and Modigliani and their collaborators. In the second part we then analyze the impact on the economy of given scal policies, without asking why those policies would or should be enacted. This positive analysis contains the study of the timing of taxes, social security and unemployment insurance. In the third part we then turn to an investigation on how scal policy should be carried out if the government is benevolent and wants to maximize the happiness of its citizens. It turns out to be important for this study that the government can commit to future policies (i.e. is not allowed to change its mind later, after, say, a certain tax reform has been enacted). Since this is a rather strong assumption, we then identify what the government can and should do if ix

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PREFACE

it knows that, in the future, it has an incentive to change its policy. Finally, in part 4, if time permits, we will discuss how government policies are formed when, instead of being benevolent, the government decides on policies based on political elections or lobbying by pressure groups. This area of research, called political economy, has recently made important advances in explaining why economic policies, such as the generosity of unemployment benets, dier so vastly between the US and some continental European countries. We will study some of the successful examples in this new eld of research.

Part I

Introduction

1

3 In the rst part of these notes we want to accomplish two things. First, we want to get a sense on what the government does in modern societies by looking at the data describing government activity. Then we want to construct and analyze the basic intertemporal household decision problem which we will use extensively to study the impact of scal policy on private decisions of individual households, and thus the entire macro economy. We start with the simplest version of the model in which households live for only two periods, and then extend it to the standard life cycle model of Modigliani and Ando.

4

Chapter 1

Empirical Facts of Government Economic ActivityBefore proposing theories for the eect and the optimal conduct of scal policies it is instructive to study what the government actually does in modern societies. We will look at data for Germany, the US and perform some international comparisons.

1.1