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Gennany Cataloging-in-Publication Data applied for Die Deutsche Bibliothek - CIP-Einheitsaufnahme Wolff, Jessica de: The political economy of fiscal decisions: the strategic role of public debtl Jessica de Wolff. - Heidelberg; New York: Physica-Verl., 1998 (Contributions to economics) Zugl.: Berlin, Techn. Univ., Diss. ISBN 978-3-7908-1130-8 ISBN 978-3-642-58993-5 (eBook) DOI 10.1007/978-3-642-58993-5 This work is subject to copyright All rights are reserved, whethcr the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illus trations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks. Duplication of this publication or parIS thcreof is permitted only under the provisions of the German Copyright Law of September 9, 1965, in its current version, and permission for use must always be obtained from Physica-Verlag. Viola tions are liable for prosecution undcr the German Copyright Law. © Springer-Verlag Berlin Heidelberg 1998 Originally published by Physica-Verlag Heidelberg New York in 1998 The use of general descriptive names, registered names, trademarks, etc. in this publica tion does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore frec for general use. Softcover Design: Erich Kirchner, Heidelberg SPIN 10684458 88/2202-5 4 3 2 1 O - Printed on acid-frec paper To Dati Preface This Ph.D. was conceived and written while I was working at the Economics Department of the Technical University Berlin. First of all, I want to thank my supervisor Prof. Dr. Jiirgen Kromphardt for his encouragement and his decisive comments. I am especially grateful to Prof. Dr. Georg Meran for serving as my second advisor. Avner Shaked accompanied the development of this study over the years with helpful comments on various versions and with moral support. I have also benefitted from very helpful comments by Pio Baake, Diana Barrowdough, Patrick Bolton, Gesa Bruno-Latocha, Sven Feldmann, Gilat Levy, Torsten Persson and Ailsa Roell as well as from partic ipants at the Doktorandenkolloquium at the TU Berlin and seminar partici pants at ECARE at the Universite Libre Brussels, at the 7th summer school in Economic Theory on Political Economy at the Institute for Advanced Studies at the Hebrew University of Jerusalem, at the EEA'96 and ESEM'96 con ferences in Istanbul and at the Free University Berlin. A very special thanks goes to Heinz-Dieter Kretzmer who saved me when my work got lost in the depths of my computer. Moreover, I would like to thank Wenzel Matiaske and Thorsten Wichmann for computer assistance and Stephanie Behrendt for guiding me around the bureaucratic hurdles of the Promotionsverfahren. Finally, financial support from the Victor Rothschild Foundation, the Euro pean Economic Association and the Gesellschaft von Freunden der TU Berlin is gratefully acknowledged. Of course, I am to blame for all remaining errors and imperfections. Berlin, March 1998 Table of Contents 1. Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 2. The Evolution of Public Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 3. Literature Survey: The Political Economy of the Govern- ment Budget ............................................. 11 3.1 The Tax-Smoothing Theory of the Government Budget. . . . .. 12 3.2 Intergenerational Redistribution. . . . . . . . . . . . . . . . . . . . . . . . .. 16 3.3 Intragenerational Geographical Redistribution. . . . . . . . . . . . .. 19 3.4 Government Fragmentation and Duration and the Electoral System ................................................ 21 3.4.1 A War of Attrition Model. . . . . . . .. . . . . . . . . . . . . . . .. 22 3.4.2 Empirical Findings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 25 3.5 Debt as a Strategic Instrument. . . . . . . . . . . . . . . . . . . . . . . . . .. 28 3.5.1 Persson/Svensson [1989]: Why a Stubborn Conserva- tive Would Run a Deficit: Policy With Time-Inconsistent Preferences ....................... . . . . . . . . . . . . . .. 30 3.5.2 Alesina/Tabellini [1990a]: A Positive Theory of Fiscal Deficits and Government Debt .. . . . . . . . . . . . . . . . . . .. 32 3.5.3 Aghion/Bolton [1990]: Government Domestic Debt and the Risk of Default: A Political Economic Model of the Strategic Role of Debt ............................ 36 3.5.4 Milesi-Ferretti/Spolaore [1994]: How Cynical Can an Incumbent Be? Strategic Policy in a Model of Govern- ment Spending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 43 3.5.5 A Critical Evaluation of the Models and Implications for this Thesis ................................... 46 4. Introduction to the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 49 4.1 The Model's Time Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . .. 49 4.2 The Main Novelties of the Model. . . . . . . . . . . . . . . . . . . . . . . .. 50 4.2.1 The Two-Dimensionality of Voters. . . . . . . . . . . . . . . . .. 50 4.2.2 Endogenizing the Electoral Outcome: Debt as a Strate- gic Instrument ............ . . . . . . . . . . . . . . . . . . . . . .. 54 x Table of Contents 4.3 Further Assumptions ofthe Model. . . . . . . . . . . . . . . . . . . . . . .. 56 4.3.1 Two Periods. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 57 4.3.2 Two Ideological Parties ........................... 58 4.3.3 No Default ...................................... 58 4.4 The Interdependencies of the Model ...................... 59 5. The Model ............................................... 67 5.1 The Agents and their Decisions .......................... 67 5.l.1 The Consumers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 67 5.1.2 The Government. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 67 5.1.3 Elections........................................ 69 5.2 Solving the Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 70 5.2.1 The Problem to Be Solved. . . . . . . . . . . . . . . . . . . . . . . .. 70 5.2.2 The Consumers' Savings Decision .................. 70 5.2.3 The Government's Constraints. . . . . . . . . . . . . . . . . . . .. 72 5.2.4 The Model's Mathematical Structure ............... 74 5.2.5 Neutrality....................................... 74 5.3 Elections and the Economy's Taste-Income Distribution. . . .. 77 5.3.1 Voting and the Indifferent Voters. . . . . . . . . . . . . . . . . .. 77 5.3.2 The Role of the Economy's Taste-Income Distribution 81 6. The Implications for Fiscal Policy ........................ 89 6.1 A General Example.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 90 6.2 Fiscal Policy in Our Model .............................. 90 6.3 The Long Run Utility Function in General Form and its Derivative With Respect to p ........ . . . . . . . . . . . . . . . . . . .. 92 6.4 The Optimal Fiscal Policy of an R-Government ........ . . .. 95 6.4.1 Type A Economy.. . .. . . . . . . .. . . . .. . . .. . . . . . . . . . .. 96 6.4.2 Type B Economy. . ... . .. . . .. . . .. . . .. .... . . .. . . .. 98 6.5 The Optimal Fiscal Policy of an L-Government ............ 100 6.5.1 Type A Economy ................................. 100 6.5.2 Type B Economy ................................ 103 6.6 Uncertainty ............................................ 103 7. Conclusions ............................................... 109 A. Appendix ................................................. 115 A.l General Government Net Debt-to-GDP Ratios, 1960-1990 ... 115 A.2 From Equation (5.6) to Equation (5.7) .................... 115 A.3 Total Savings or How to Get Equation(5.9) ................ 117 A.4 Proof: The Left-Wing Party Sets a Higher Tax Rate, T2(L) > T2(R) ................................................. 118 A.5 The Variables Relevant for the Model's Political Dimension .. 120 A.5.1 Optimal Individual Savings ........................ 120 A.5.2 Total Savings .................................... 120 Table of Contents xi A.5.3 The Optimal Tax Decision in the Second Period ...... 121 A.5.4 An Additional Equation: The Consumers' Budget Con- straint .......................................... 121 A.6 The Relationship Between iiI and p ....................... 121 A.7 How to Get from Equation (5.14) to Equation (5.15) ........ 122 A.8 Proof: The Curve of Indifferent Consumers is Decreasing in m or How to Get Equation (5.16) ........................ 122 A.9 Proof: The Indifferent Consumers' Curve's Reaction to Changes in p ................................................... 123 A.10 Proof: Parties' Reactions when the Debt to Repay Increases . 128 A.10.1 T2(') as a Function of p ............................ 129 A.10.2 Y2(-) as a Function of p ........................... 130 A.11 The Problem of Intersecting J.l-Curves ..................... 130 A.12The Optimal Levels of Private and Public Goods, Xl,X2,ih and ih ................................................ 132 A.13 The Long Run Utility Function to Be Maximized in Reduced Form ................................................. 135 A.14 The Derivative of Up With Respect to p .................. 136 A.15 The Long Run Utility Functions for the Special Cases of Our Model ................................................. 137 A.16 The Influence of the Beliefs on the Optimal Policy Choice iii . 142 B. References ................................................ 145 List of Figures 2.1 Debt-to-GDP Ratios in Selected OECD economies I ............ 8 2.2 Debt-to-GDP Ratios in Selected OECD economies II. . . . . . . . . . . . 8 3.1 Distortionary Taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 13 3.2 Tax Smoothing Policy. . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 14 3.3 Optimal Default Policies .................................... 42 4.1 The Model's Time Structure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 50 4.2 The Median Voter Model With Ideological Parties. . . . . . . . . . . . .. 51 4.3 A Two-Dimensional Distribution. . . . . . . . . . . . . . . . . . . . . . . . . . . .. 53 4.4 The Set of Indifferent Consumers in Taste-Income Space. . . . . . . .. 54 4.5 Election Manipulation in the Two-Dimensional Model. . . . . . . . . .. 55 4.6 A Progressive Tax Scheme. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 57 4.7 The Interdependencies of the Model .......................... 59 4.8 Parties' Reactions as p Increases. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 63 4.9 The Curve of Indifferent Consumers for Different Interest Rates, Pl > P .................................................... 64 4.10 The Curve of Indifferent Consumers in Type A and B Populations 65 5.1 The Economy's Distribution and the Two Representative Voters.. 69 5.2 The Set of Indifferent Consumers. . . . . . . . . . . . . . . . . . . . . . . . . . . .. 78 5.3 The Curve of Indifferent Consumers as a Function of p, Pl > P . .. 80 5.4 The Sets of Indifferent Consumers for Different Fiscal Policies. . .. 81 5.5 Discontinuous Elections' Outcome Function. . . . . . . . . . . . . . . . . . .. 82 5.6 Areas With Ordered p-Curves. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 82 5.7 Curves ofIndifferent Consumers in a Type A Economy.. . . . . . . .. 83 5.8 Curves of Indifferent Consumers in a Type B Economy.. . . . . . . .. 83 5.9 Elections' Outcome Function in a Type A Economy. . . . . . . . . . . .. 84 5.10 Elections' Outcome Function in a Type B Economy ............ 84 5.11 J.I. as an Indicator for the Political Couleur of a Society (Type A Economy) ................................................. 86 5.12 J.I. as an Indicator for the Political Couleur of a Society (Type B Economy) ................................................. 86 6.1 The Global Long-Run Utility Function of a P-Party ............ 91