This revision: August 2012

Growth and scal policy: a positive theory

Abstract
We present a political economy theory of growth in which the government aects the growth rate both di-
rectly through public investments in infrastructure, and indirectly through the eect of taxation on learning
by doing. Policy choices are made by a legislature consisting of representatives elected by geographically-
dened districts. The legislature can raise revenues via a discretionary income tax and by issuing public
debt. We study the equilibrium relationship between the dynamics of debt and the growth rate of the
economy. We use the model to study the impact of an austerity program! in which a country is forced
to reduce the debt"#$P ratio. To quantify these eects, the model is calibrated to the %.&. economy.
'evon (arseghyan
$epartment of )conomics
*ornell %niversity
+thaca ,- ./012
lb3/45cornell.edu
6arco (attaglini
$epartment of )conomics
Princeton %niversity
Princeton ,7 801//
mbattagl5princeton.edu

For useful comments and discussions we thank Alberto Alesina, Marco Bassetto, Stephen Coate, Guido Tabellini
and the participants to the 2012 emmers pri!e conference, the "th CS#F$%G%#& S'mposium on #conomics and
%nstitutions, and 2012 B#& Summer %nstitute(
1 Introduction
The rapid deterioration of the scal position of the U.S. federal government in the aftermath of the
great recession of 2008 has brought the spotlight on the long term eect of public debt on the real
econom. !ederal debt in the U.S. is currentl its highest level since the decade follo"ing #orld
#ar $$. %oncerns over the gro"th of public debt has led to the &udget %ontrol Act of 2011 that
"ill trigger automatic across'the board cuts in spending if a decit reduction bill of at least 1.2
trillions is not passed b (anuar 201). !or the U.S. *and for all other countries "ith high levels
of debt
1
+ the ,e -uestions are: To "hat e.tent do high levels of public debt permanentl reduce
the gro"th potential of the econom/ Are austerit programs eective in reducing debt0123
and in increasing gro"th potential and "elfare/ 4o" should the be designed/
To ans"er these -uestions "e need a theor in "hich gro"th and scal polic are 5ointl de'
termined in e-uilibrium. The literature on gro"th6 ho"ever6 has traditionall been more focused
on the private sector6 emphasi7ing the role of entrepreneurial innovation and technological ad'
vancement. #ith fe" notable e.ceptions6 scal polic has been ignored or assumed as e.ogenous.
8ven in the research that has e.plicitl considered a role for the government6 public polic is
assumed to balance the budget in ever period and public debt is not studied. 9et6 scal polic
has changed in important "as during last four decades6 "ith potentiall signicant implications
for macroeconomic outcomes *see !igure 1+. $n the post ##$$ era6 after bottoming at around
2:; of 123 during the seventies6 the debt level in the U.S. has been steadil increasing over time6
surpassing <0; b the end of 2010. 2uring this period6 both the ta. revenue and the provision
of public goods and infrastructure have declined as shares of 1236 "ith public investment falling
rather dramaticall.
2
$n this paper "e present a political econom theor of endogenous gro"th in "hich the gov'
ernment can issue debt to nance e.penditures. $n our theor the gro"th rate of the econom
depends on public investment and6 because of learning'b'doing6 on private citi7ens= labor suppl.
!iscal polic aects citi7ens= incentives in t"o "as: ta.ation distorts labor suppl and decits
distort the consumption0savings decision through their eect on the interest rate. 3olic choices
are made b a legislature consisting of elected representatives. 3olitical con>ict arises because
1
%n more than a half of the 1) #uro!one countries debt is o*er +0, of G-., and in /*e of them0o*er "0,(
2
These /ndin1s are robust to alternati*e accountin1 de/nitions of public 1oods and public in*estments 2see
Section )(+3(
1
1970 1980 1990 2000 2010
30
40
50
60
70
80
Federal Debt, % of GDP


actual
estimate
1970 1980 1990 2000 2010
1
2
3
4
5
Public Investment and R&D, % of GDP


Public Investment
Public R&D
1970 1980 1990 2000 2010
8
10
12
14
16
18
20
Tax Revenue, % of GDP


Total
Net of Social Security
1970 1980 1990 2000 2010
4
6
8
10
12
Public Goods, % of GDP


Total
Net of Defense
!igure 1: !iscal trends in the U.S. econom.
representatives in the legislature have incentives to vote for policies that favor their o"n con'
stituencies and citi7ens benet onl partiall from local public goods provided to constituencies
to "hich the do not belong. The level of public debt and the level of productivit in the econom
are state variables and create a dnamic lin,age across polic'ma,ing periods. #e use the model
to provide a positive theor of gro"th and scal polic and to evaluate the normative eects of
austerit programs that limit the abilit of the government to issue debt. Since our theor is
designed as a model for a large closed econom6 "e calibrate it to the U.S. econom to assess its
predictions -uantitativel.
Starting from an initial state6 the econom in our model converges to"ard a balanced gro"th
path in "hich consumption6 public investment6 public good provision6 public debt and productivit
gro" at the same constant rate. Under standard assumptions6 on the balanced gro"th path the
debt'to'123 ratio is positive and the gro"th rate of the econom is ine?cientl lo". The
transition to the balanced gro"th path is characteri7ed b "hat "e call the shrinking government
2
eect: public debt gro"s faster than 1236 provision of public goods and infrastructure gro"s
slo"er than 1236 and the ta. rate declines. 8ectivel6 as the econom converges to its balanced
gro"th path6 a decreasing fraction of 123 is devoted to providing public services. These ndings6
along "ith our calibration results6 are in line "ith the U.S. *!igure 1+.
The shrin,ing government eect is a conse-uence of the political distortion and its eect on the
interest rate. 3olitical distortions induce the ruling coalition@the coalition in the legislature that
controls scal polic@to use debt to shift the burden of ta.ation to the future. $n ever period
the ruling coalition trades o an e.tra increase in public goods toda for their o"n districts6 "ith
a more than proportional reduction in public goods in the follo"ing period for all districts. The
former option is al"as more appealing because the ruling coalition can better target current e.'
penditures to their o"n districts rather than the future e.penditure. %onse-uentl6 debt increases6
forcing legislators to increase the primar surplus to service its cost. Aegislators nd it optimal to
do this b reducing e.penditures rather than increasing ta.es: #hen e.penditures are reduced6
disposable income and savings increase6 and so the interest rate is held do"n. To the contrar6
"hen ta.es are increased6 disposable income and savings decline6 so the interest rate goes up.
An interesting implication of the shrin,ing government eect is that6 as debt0123 increases6
the gro"th rate of the econom does not necessaril go do"n. This occurs because the decline in
ta.ation ma induce an increase in labor suppl and6 hence6 in learning'b'doing. This nding
ma help e.plain the evidence suggesting a non monotonic relationship bet"een debt and gro"th.
3
The fact that there is not necessaril a monotonic relationship bet"een public debt and gro"th6
ho"ever6 should not be interpreted as a sign that debt has a limited impact on "elfare. $n our
model debt al"as reduces "elfare6 even if it does not reduce gro"th: the reduction in "elfare is
induced b the reduction in public services.
To stud ho" countries can limit the ine?ciencies in gro"th highlighted above6 "e stud
a simple but plausible tpe of an Bausterit program.C The program is characteri7ed b t"o
features6 a target level for debt and a time hori7on: The countr is re-uired to bring do"n debt
to a given target level over a given number of ears. Three ndings emerge from this e.ercise.
!irst6 in our calibration6 austerit programs tpicall increase "elfare if the are not e.cessivel
ambitious. Second6 there is no Bone'si7e'ts'allC austerit program: the optimal plan depends
on the fundamentals and on the initial state of the econom. The higher is the accumulated
3
See for e4ample &einhard and &o1o5 620117, 8umar and 9oo 620107 and Checherita and &other 620107(
)
level of debt6 the less aggressive the programs should be6 both in terms of the debt target and
in terms of duration. The third nding is that the gro"th rate is a poor measure of the success
of the program. Dn the transition path of the optimal austerit program6 gro"th is belo" the
pre'austerit level6 but "elfare is increasing.
Dur paper is related to t"o strands of literature. !irst the literature on endogenous gro"th.
Eost of this research is normative and focused on evaluating the eects of ta.ation on the capital
accumulation process rather than at e.plicitl modelling polic ma,ing *Febelo G1HH0I6 Jing and
Febelo G1HH1I6 &arro G1HH1I6 Sto,e and Febelo G1HH)I6 (aimovich and Febelo G2012I+. 3ositive
theories of gro"th have been presented in the conte.t of the research studing the political econom
of redistribution. The basic idea developed in these papers is that income ine-ualit determines
ta. polic and therefore gro"th *&ertola G1HH)I6 3erotti G1HH)I6 Saint'3aul and Kerdier G1HH)I6
Alesina and Fodri, G1HHLI6 3ersson and Tabellini G1HHLI6 Jrusell and Fios'Full G1HHHI6 &enabou
G2000I6 Saint 3aul G2001I+. A common trait of these theories *both normative and positive+ is
that scal polic is assumed to balance the budget in ever period and so public debt is ruled
out b assumption.
4
Dur paper contributes to this endogenous gro"th literature in t"o "as.
!irst6 "e allo" for a richer polic space "ith public debt. Second6 "e propose an e.plicit dnamic
model of political decision ma,ing in "hich rational for"ard loo,ing polic'ma,ers bargain for the
polic outcome. To do this6 "e focus on a smmetric model in "hich there is no redistribution
of "ealth bet"een citi7ens. Dur focus is on the e?cienc of policies.
The second strand of literature to "hich our paper is related is the research on the political
econom of public debt *3ersson and Svensson G1H8HI6 Alesina and Tabellini G1HH0I6 &attaglini
and %oate G2008I among others+. These models are specicall aimed at modelling public debt6
but the do not allo" for gro"th and ma,e assumptions that simplif the determination of the
e-uilibrium interest rate. These t"o issues are intimatel connected. The ,e assumption in
this literature is that preferences are -uasi'linear: in this case the e-uilibrium interest rate is
constant and independent of the chosen policies.
5
&alanced gro"th6 ho"ever6 is not consistent
4
An e4ception is Saint$.aul 61::27 where the 1o*ernment can issue debt( The main result of this paper is that
debt is not welfare impro*in1( The paper is normati*e and does not present a theor' of public debt(
5
%n the conte4t of normati*e models in which policies are chosen b' a bene*olent planner, the strate1ic interac$
tion between /scal polic' and interest rates has been /rst studied b' Stoke' and ;ucas 61:"<7 and then e4tended
to a *ariet' of en*ironments b', amon1 others, Martin 6200:7 who allows for the presence of mone', &o1ers 61:":7,
=cchino 620127 and -ebortoli and unes 620127 who allow for endo1enous public spendin1, and Ai'a1ari et al 620027
and Shin 6200+7 who consider stochastic economies(
L
"ith these preferences: this is "h modelling endogenous gro"th and the endogeneit of interest
rates simultaneousl is necessar. As "e sho" in this paper6 the endogeneit of interest rates is
crucial to understanding the dnamics of scal polic in large closed economies. A neoclassical
gro"th model in "hich the government can e.propriate capital in the presence of political econom
frictions is presented b Aguiar and Amador G20106 2012I. 2ierentl from our "or,6 this research
focuses on the case of a small open econom for "hich the interest rate is e.ogenous: because of
this it does not stud the interaction bet"een scal polic6 interest rates and political distortions
that is the primar ob5ective of our "or,. !inall6 there is a signicant literature studing the
political econom of decit reduction programs both theoreticall and empiricall.
6
Mone of the
papers cited above has e.plicitl studied the lin, bet"een debt6 scal polic and the endogenous
gro"th process.
The organi7ation of the remainder of the paper is as follo"s. Section 2 outlines the model.
Section ) characteri7ed the political e-uilibrium. $n Section L "e stud the dnamics of the model
using parameters calibrated to the U.S. econom. $n Section : "e use the model to stud the
eect of an austerit program and "e stud ho" the optimal austerit program depends on the
environment. Section < concludes.
2 Model
The economy A continuum of innitel'lived citi7ens live in n identical districts inde.ed b
i N 1, ..., n. The si7e of the population in each district is normali7ed to be one. There is a single
nonstorable consumption good6 denoted b c6 that is produced using a single factor6 labor6 denoted
b l. There is also a set of n local public goods6 denoted b N
_

i
_
i
6 that can be produced
from the consumption good. The variables at time t "ill be denoted "ith a subscript t. #e "ill
stud e-uilibria in "hich all agents from the same district j ma,e the same economic choices.
The citi7ens en5o the consumption good6 benet the local public goods6 and suppl labor.
!or most of the paper "e assume that each citi7en=s preferences in district i are represented b
6
Amon1 theoretical contributions we ha*e Alesina and -ra!en 61::17, Grilli and -ra!en 61::<7, -ra!en 6200173(
More than on stud'in1 the e5ects of de/cit reduction, this literature is focused on stud'in1 when de/cit reduction
pro1ram are chosen( The e5ects of a balanced bud1et rule has been studied b' A!!imonti, Batta1lini and Coate
620117( Amon1 empirical contributions in this literature we ha*e Gia*a!!i and .a1ano 61::07, Mc-ermott and
9escott 61::+7, Alesina and Arda1na 61::"7, Alesina, .erotti and Ta*ares 61::"7, Arda1na 6200>7(
:
the follo"ing per period utilit function:
u*c
t
, l
t
,
t
+ N log *c
t
*1 l
t
+

+ O
0
log
_
_

i
t
_

j

j
t
_
1
_
, *1+
"here > 06
0
> 0 and G0, 1I. This utilit describes a situation in "hich district i en5os a
direct benet from public good i6 but there ma also be an e.ternalit from *the sum of+ public
goods provided to other districts. The parameter measures the si7e of this e.ternalit: the
closer is to one6 the smaller are the e.ternalities and the more
i
benets onl the citi7ens in
district i. Since *1+ is a variation of the standard Jing6 3losser6 Febelo G1H88I utilit function
augmented for public goods6 "e "ill refer to it as J3F.
7
%iti7ens discount future per period
utilities at rate .
All local public goods are produced from the consumption good according to a linear technolog
"ith marginal rate of transformation e-ual to one. The consumption good at time t is produced
"ith the linear technolog c
t
N z
t
l
t
. The variable z
t
is interpreted as an econom "ide productivit
factor6 such as human capital. 3roductivit ma increase because of learning'b'doing in the
private econom and because of direct public investments6 I
t
*such as e.penditure on research
and development6 education6 public infrastructure6 and other productivit enhancing investments+.
Specicall6 "e assume:
z
t+1
N *l
t
+*I
t
/z
t
+ z
t
, *2+
"here l
t
N

j
l
j
t
/n is the average labor suppl6 *l
t
+ N
0
*l
t
+
1
and *I
t
/z
t
+ N
0
*I
t
/z
t
+
1
are concave functions "ith
i
6
i
> 0 for i N 0, 1 and
1
6
1
< 1. The function describes
the process of learning'b'doing: the more citi7ens "or,6 the more the learn from each other
and more productive the "ill be in the future. The function describes the benets of public
investment: The higher is public investment6 the higher is the ne.t period productivit. The
scaling b 10z
t
is standard to ensure that public investment as a fraction of output does not
shrin, to 7ero over time: $n a gro"ing econom6 the higher is productivit6 the more e.pensive it
should be in absolute terms to improve it.
8
There is a competitive labor mar,et: thus the "age rate at t is e-ual to z
t
. There is also
a mar,et in ris,'free6 one period bonds. &oth citi7ens and the government have access to this
7
9e will e4tend the anal'sis to alternati*e utilit' functions in Section >(2 where we stud' how wealth e5ects
shape the e?uilibrium beha*ior(
8
9ithout loss of 1eneralit' we could ha*e speci/ed the econom' wide le*el of producti*it' as a product of
human capital, h, and public infrastructure, @A z
t+1
B h
t+1
@
t+1
, with h
t+1
B 2lt3ht and @
t+1
B 2It/zt3 @t.
<
mar,et. The assets held b an agent in district j in period t "ill be denoted a
j
t
. The gross
interest rate is denoted
t
: a dollar "orth of bonds at time t ields
t
at time t O1.
Public Policies The government provides local public goods6 public infrastructure and can
ma,e direct monetar transfers to the districts. Eonetar transfers are uniform across districts
and are interpreted as a "elfare program smmetricall targeted to all regions. Fevenues are
raised b leving a proportional ta. on labor income and the can be supplemented b bor'
ro"ing and lending in the bond mar,et. 1overnment polic in an period t is described b
{
t
,

t
,
i
t
, ....,
n
t
, I
t
, T
t
}6 "here
t
is the income ta. rateP

t
is the amount of bonds soldP
i
t
is the
amount of public good provided to district iP I
t
is the level of infrastructure investmentP and T
t
is
the uniform transfer. #hen

t
is negative6 the government is buing bonds. $n each period6 the
government must also repa the bonds that it sold in the previous period "hich are denoted b

t
. The government=s initial debt level in period 1 is
0
6 agents initial assets are a
j
0
N a
0
N
0
n
.
1overnment policies must satisf three feasibilit constraints. !irst6 ta. revenues and net
borro"ing must be su?cient to cover public e.penditures. To see "hat this implies6 consider
a period in "hich the initial level of government debt is
t
and the interest rate is
t
. Total
e.penditure is

j

j
t
O I
t
O T
t
O
t
6 ta. revenue is
t
z
t

j
l
j
t
6 and revenue from bond sales is

t
/
t
. So the government budget condition is:

t

t
_
_

t
O

j
t
OI
t
OT
t

t
z
t

j
l
j
t
_
_
0. *)+
Second6 to ,eep the polic space compact in the legislator=s ma.imi7ation problem6 "e assume that
local public goods6 public investment and transfers as fractions of 123 can not be smaller than
some minimal levels: I
t
/y
t
I6
i
t
/y
t
g and T
t
/y
t
T for all i6 "here I 06 g > 0 and T 0.
The lo"er bound T is interpreted as commitments on transfers ta,en in previous legislations that
are not directl modelled here *as for e.ample Social Securit6 Eedicare and Eedicaid+. Third6
the feasible debt6 relative to 1236 is bounded:
t
/y
t

_
b, b

. This constraint rules out 3on7i

schemes and re>ects the fact that if debt6 relative to 123 is too high6 then the government "ill
not be able to repla it.
Market equilibrium and political decision making Using the rst order necessar condi'
tions for a citi7en=s problem6 labor and consumption choices in district i at time t can be repre'
Q
sented as functions of the policies and net savings a
i
t
a
i
t+1
/
t
. $n the follo"ing "e "ill stud a
smmetric e-uilibrium in "hich a
i
t
N a
t
as "ell as c
i
t
N c
t
and l
i
t
N l
t
for an district i. Since for
an given government polic the interest rate must clear the mar,et for one period bonds6 in such
an e-uilibrium "e have a
t
a
t+1
/
t
N
1
n
*
t

t+1
/
t
+. Using *)+ and households= optimalit
conditions "ith respect to consumption and labor6 "e can therefore e.press the citi7ens= choices
as functions of current public policies onl. $t is useful to e.press all the variables in terms of
123. 2ene g
i
t
N
i
t
/y
t
6 I
t
N I
t
/y
t
, T
t
N T
t
/y
t
and p
t
N
_
,
_
g
j
t
_
j
, I
t
, T
t
_
. Aabor suppl can
then be "ritten as l *p
t
+6 "here:
l*p
t
+ N
1
t

_
1
1
n
_
I
t
O

j
g
j
t
__
O1
t
. *L+
%onsumption can be "ritten as c*p
t
, z
t
+ N z
t
c*p
t
+6 "here:
c*p
t
+ N
*1
t
+
_
1
1
n
_
I
t
O

j
g
j
t
__

_
1
1
n
_
I
t
O

j
g
j
t
__
O1
t
. *:+
These e.pressions allo" us to "rite citi7en i=s utilit function onl as a function of current public
policies and the level of productivit:
u*p
t
, z
t
+ N *1 O
0
+ log z
t
OU*p
t
+ O
0
log
_
_
g
i
t
_

j
g
j
t
_
1
_
, *<+
"here U*p
t
+ can be interpreted as the indirect per period utilit function given p
t
from consump'
tion and labor scaled b productivit z
t
, as specied in the Appendi..
9
#e can also "rite the
resource constraint of the econom as:
*p
t
, z
t
+ N z
t
nl*p
t
+
_
1 c*p
t
+
1
n
_
I
t
O

j
g
j
t
_
_
0.
Aet !*p+ N *l*p++*I nl*p++6
10
then "e can "rite z

N !*p+z. The e.pression for the interest

rate no" becomes:

1
t
*p
t
, p
t+1
+ N
U
c,t+1
*p
t+1
, z
t+1
+
U
c,t
*p
t
, z
t
+
N
c*p
t
+
!*p
t
+c*p
t+1
+
. *Q+
!rom *L+'*:+ it is clear that the impact of public investment and transfers aect all districts in the
same "a. The districts are heterogeneous onl "ith respect to the amount of local public goods
_
g
j
t
_
j
the receive. These are the variables over "hich there is political con>ict in the legislature.
9
See Appendi4 )(2 for details(
10
ote that from 223 we ha*e z

B 2l32I/z3 z, so normali!in1 I b' y, we ha*e z

B Z2p3z as noted in the te4t(

8
1overnment polic decisions are made b a legislature consisting of representatives from each
of the n districts. Dne citi7en from each district is selected to be that district=s representative.
Since all citi7ens have the same polic preferences6 the identit of the representative is immaterial
and hence the selection process can be ignored. The legislature meets at the beginning of each
period. To describe ho" legislative decision'ma,ing "or,s6 suppose the legislature is meeting at
the beginning of a period in "hich the current level of public debt is b
t
. The process has t"o
phases: government formation and bargaining in the government.
11
$n the rst phase6 one of the
legislators is randoml selected to form a government6 "ith each representative having an e-ual
chance of being recogni7ed. A government is a cabinet of G representatives and a polic platform
{b

t
,
t
, "
t
, I
t
, T
t
}, "here "
t
is the aggregate amount of public goods. $n the second phase6 the
cabinet members allocate the local public goods. The initial government formateur proposes
a provisional distribution of the local public goods
_
g
j
t
_
j
. $f the rst proposal is accepted b
# G cabinet members6 then it is implemented and the legislature ad5ourns until the beginning
of the ne.t period. At that time6 the legislature meets again "ith the dierence being that the
initial level of public debt is b

t
and productivit is given b *2+. $f6 on the other hand6 the rst
proposal is not accepted6 another member of the government is chosen to propose an alternative
redistribution of
_
g
j
t
_
j
. The process continues until a proposal is approved b the cabinet. #e
assume that each proposal round ta,es a negligible amount of time.
12
3 The political equilibrium
&efore "e characteri7e the political e-uilibrium in the econom described in the previous section6
it is useful to highlight the ,e determinants of gro"th in our econom. Dn a balanced gro"th
path "e should e.pect income6 consumption6 investment to gro" at the same constant rate $ and
per capita productivit and the real interest rate to remain constant. $n an econom "ith a non
trivial public sector "e should also e.pect public e.penditure to gro" at the same rate as the
11
A similar bar1ainin1 process in which /rst a formateur selects the 1o*ernment and then the cabinet members
bar1ain o*er the allocation of tar1etable transfers is presented b' Baron and -iermeier 620017( %n Baron and
-iermeier 620017 the bar1ainin1 phase consists in a take it or lea*e it o5er with a status ?uo polic' in case a
?uali/ed maCorit' in the 1o*ernment is not reached(
12
=ur bar1ainin1 process 1i*es as special cases man' bar1ainin1 processes used in the political econom' literature(
9hen G B 1 the polic' is chosen b' a randoml' selected dictator who ma4imi!es his own utilit' as in Alesina and
Tabellini 61::07( As we will show, when G > 1 and q B G the polic' is chosen to ma4imi!e the a11re1ate utilit' of
a coalition of si!e G as in Batta1lini and Coate 620127( 9hen G B q B n, the polic' coincide with the utilitarian
optimal polic'(
H
private econom6 and ta. revenues to be a constant fraction of income:
13
R

N
RI
I
N
RT
I
N $6 R N 0. *8+
Using these conditions6 it is eas to see that in our econom *L+'*Q+ impl that the gro"th rate of
all the ,e variables is determined b the gro"th rate of productivit: $ N Rz/z. 8ven before
"e start studing political decision ma,ing6 "e can see the role of scal polic on $. !rom *2+6
in the stead state "e have:
$ N
Rz
z
N !*p+ 1, *H+
"here6 as dened above6 !*p+ N *l*p++*I nl*p++. The gro"th rate is a function of the primitives
of the econom and of public policies. This is not in itself a ne" observation6 since it has been
long recogni7ed that in endogenous gro"th models public policies have a long term eect on the
gro"th rate *see Febelo G1HH1I+. The interesting point is that6 in our model6 e.plaining scal
polic is necessar to obtain an endogenous theor of gro"th.
%ondition *H+ leaves t"o open -uestions. !irst6 "hat determines the long run scal polic6 and
hence the gro"th of the econom on the balanced gro"th path/ As it can be seen from *H+6 this
econom ma have either positive or negative gro"th in the stead state6 since there is no a prior
reason to e.pect $ > 0. Second6 "hat are the dnamics of the polic variables/ An econom
ma reach the stead state "ith an increasing ta. rate and decreasing public investment6 or "ith a
decreasing ta. rate and decreasing investment6 or the reverse. Studing the path of the econom
to"ards the balanced gro"th path is one "a to shed light on the long run trends of scal polic
variables. To ans"er these -uestions "e need an e.plicit theor of public polic ma,ing. #e
address these issues in the ne.t t"o sections. $n Section ).1 "e characteri7e e-uilibrium behavior.
$n Section ).2 "e derive the implications for the balanced gro"th rate and for the transition path
converging to it.
3.1 Equilibrium behavior
To characteri7e behavior "hen policies are chosen b a legislature6 "e loo, for a smmetric Ear,ov
perfect e-uilibrium *SE8+ in "hich plaers= strategies depend onl on the level of public debt per
unit of human capital6 i.e. b
t
N
t
/z
t
. As "e formall sho" belo" there is no loss of generalit in
13
=b*iousl' these conditions need not be satis/ed on the path of con*er1ence( The predictions of the model
for the con*er1ence path will be discussed in Section <(2( in 1reater detail(
10
adopting b
t
as a state variable.
14
A smmetric Ear,ov e-uilibrium can be formall dened b a
collection of polic functions p*b+ N {*b+, I*b+, T*b+, b

*b+, g*b+, g
c
*b+}. 4ere *b+6 I*b+ and T*b+
are the ta. rate and the share of 123 spent on public investment and transfers proposed in state
b. The function b

*b+ is the ne" level of debt normali7ed b the future level of human capital6 i.e.

/z

"here z

N !*p*b++z.
15
The remaining t"o functions describe ho" local public goods are
distributed in the econom. $n a SE8 the proposer randoml selects G 1 legislators to form a
governmental cabinet6 choosing them from the remaining n 1 legislators "ith e-ual probabilit.
The proposer provides su?cient local public goods to # cabinet members to guarantee their vote6
and as little as possible to the others *in the cabinet or outside+. The functions g*b+ and g
c
*b+
are the shares of 123 of the public good proposed for6 respectivel6 the proposer=s district and
the other districts in the minimal "inning coalition. All the other representatives e.cluded from
the minimal "inning coalition receive the minimal share of 123 possible6 g.
As standard in the theor of legislative voting6 "e focus on "ea,l stage undominated strate'
gies6 "hich implies that legislators vote for a proposal if the prefer it *"ea,l+ to continuing on
to the ne.t proposal round. #e focus6 "ithout loss of generalit6 on e-uilibria in "hich6 at each
round6 proposals are immediatel accepted b at least # legislators so that6 on the e-uilibrium
path6 no meeting lasts more than one proposal round. #e sa that an e-uilibrium is smooth if
the polic functions are continuousl dierentiable in b. $n the reminder of the paper "e focus
the analsis on smooth e-uilibria. This propert is satised b construction in all e-uilibria
computed in Section L.
To characteri7e the e-uilibrium strategies consider the problem faced b the proposer. The
proposer chooses the policies to ma.imi7e the utilit of his o"n district under t"o sets of con'
straints. !irst6 the budget constraint and the feasibilit constraints that "e have described in the
previous section. Second6 an incentive compatibilit constraint that guarantees that the proposal
is voted b a -ualied ma5orit. To be approved6 the policies must be such that:
U*p+ O
0
log
_
*g
c
+

j
g
j
_
1
_
O%*b

, z

+ N %
G
*b, z+, *10+
14
Strate1ies can not depend on the current le*el of debtDG-. since G-. is itself a function of current policies(
The debtDG-. ratio at time t is t/ztnl2pt3( 9hile t/zt is a state inherited from the past, pt is a control *ector
chosen at t(
15
The future le*el of debt in absolute terms can therefore be e4pressed in terms of the current policies as
Z2p2b33z b

2b3( The future debt in terms of future G-. depends on future policies so it is indeterminate at the
time b

2b3 is chosen( %n e4pectation it is b

2b3/2nl2b

2b33 where l2b

2b3 is future labor suppl' in state b

2b3(
11
"here z

N !*p+z is the e.pected productivit level after polic p is implemented and %

G
*b, z+ is
the outside option of a cabinet member. The left hand side of this constraint is the e.pected
utilit of accepting the proposal for a member of the minimal "inning coalition "ho receives a
level g
c
*b+ of local public good. The outside option of a cabinet member6 %
G
*b, z+6 is the e.pected
utilit of voting no and therefore moving to the stage of the bargaining game in "hich a ne"
government member is randoml selected.
16
The ne.t result sho"s that *10+ imposes a precise
relationship bet"een g*b+ and g
c
*b+:
Lemma 1. In equilibrium, the incentive compatibility constraint (10) is satised if and only if
g
c
*b+ N g*b+
Q(G,q)
g
(1Q(G,q))
, where &*G, #+ N
1
Gq+1
*0, 1I.
Aemma 1 sho"s that the bargaining process forces the proposer to provide a level of por, to the
members of the minimal "inning coalition e-ual to a geometric average of the level he assigns to
his o"n district and the level he assigns to the districts outside the coalition6 g. Total e.penditure
in public goods6 moreover is a function of g onl: "*g+ N g O*# 1+g
Q(G,q)
g
(1Q(G,q))
O*n#+g.
$t should be noted that the "eight on g*b+ is increasing function of #: the larger is #6 the more
the proposer is forced to internali7e the "elfare of the other government members. $ndeed6 "hen
the voting rule is unanimous and so # N G6 "e have g
c
N g.
17
As seen in Section 26 the citi7ens= per period indirect utilit function is separable in z and p
*see *<++. The value function has a similar representation. As sho"n in the appendi.6 "e can
e.press the value function as % *b, z+ N Alog z OV*b+ "here V*b+ is dened recursivel as:
V*b+ N U *p*b++ O
G
n
&*G, #+
0
log g*b+ OV*b

*b++6 *11+
"here A is a constant and U*p+ is specied in closed form in the Appendi..
18
Using Aemma 16
16
=f course, the incenti*e constraint needs to be satis/ed as a weak ine?ualit', re?uirin1 the left hand side to
be not smaller than the ri1ht hand side( %n e?uilibrium, howe*er, the proposer minimi!es the cost of obtainin1 a
minimal winnin1 coalition, so 2103 is alwa's satis/ed as a e?ualit'(
17
9hen the 1o*ernment deliberates b' unanimous rule 2i(e( q B G3, all the 1o*ernment members are treated in
the same wa' and the polic' is chosen to ma4imi!e the a11re1ate utilit' of 1o*ernment members(
18
The function U2p3 can be interpreted as the indirect utilit' function 1i*en polic' p2b3 from consumption
and labor, au1mented b' the e4ternalit' from the total pro*ision of public 1oods and the 2permanent3 e5ect of
current polic' p2b3 on future producti*it'( 9e represent the indirect utilit' function as in 2113 to hi1hli1ht the
di5erence with the obCecti*e function of the proposer in 2123, as discussed below( See Section )(2 for the closed
form representation of U2p3(
12
moreover6 the proposer=s problem can be "ritten as:
ma.
b

,,g,I,T
_

_
U *p+ O
0
log g OV*b

+
'.t. !*b+b

/ *b, p+ Gb O"*g+ OI OT nl*p+I N 0

b

b6 g g6 I I6 T T, G0, 1I
_

_
*12+
The representation in *11+'*12+ highlights the role of the political process on ho" policies are
chosen in e-uilibrium. #hen N 0 policies have a uniform eect on the citi7ens= "elfare. $n this
case there is no political con>ict and the proposer chooses policies to ma.imi7e the "elfare of the
representative citi7en. #hen > 06 districts value local public goods dierentl. $n this case
the proposer overestimates the "elfare eect of g. The magnitude of the overestimation depends
on
G
n
&*G, #+. #hen # N G N n6 "e have &*G, #+ N 1 and full alignment of interest across districts
is re'established. #hen G < n and0or # < G then
G
n
&*G, #+ < 1 and "e have political con>ict.
Using *11+'*12+ "e have the follo"ing characteri7ation of a political e-uilibrium:
Proposition 1. nder !"# utility functions$
If p N {, I, T, b

, g, g
c
} solves (1%) given V, and V satises (11) given p, then p is an
equilibrium policy function and % N Alog z OV is the associated equilibrium value function&
If p N {, I, T, b

, g, g
c
} is a political equilibrium with value function %, then p is a function
only of b and there are a function V of b only and a constant A such that the value function
can be represented as % N Alog z OV. 'oreover, p solves (1%) given V, and V satises (11)
given p&
The rst bullet of 3roposition 1 sho"s that to characteri7e an e-uilibrium "e can simpl stud
*11+ and *12+6 "here the state variable is b. Dnce "e have solved for the .ed'point implied b
these t"o conditions6 the value function can be immediatel found "ith the formula % N (log zOV.
The second bullet sho"s that there is no loss of generalit in considering the representation *11+
and *12+6 since all e-uilibria can be e.pressed in this "a.
3.2 alanced !rowth and transition dynamics
To stud the dnamic properties of a political e-uilibrium6 it is useful to introduce a ,e concept
in public nance ' the marginal cost of public funds *E%3!+. The marginal cost of public funds is
1)
the compensating variation for a marginal increase in ta. revenues.
19
$t is6 therefore6 a measure
of the distortion introduced b the government into the econom. To see the importance of this
concept6 consider the marginal cost of public funds associated "ith the policies {

t
, b

t
, I

t
, T

t
, g

t
}
that "ould be chosen b a benevolent planner "ho can commit to the optimal polic plan. Under
standard assumptions6 the planner aims at smoothing the cost of ta.ation over time as much as
possible. This implies that polices are chosen so that the marginal cost of public funds is e-uali7ed
over time: )*+,

t
N )*+,

t+1
for an t > 0.
20
A constant marginal cost of public funds
implies that scal polic and the gro"th level of the econom are all constant for an t > 0. $s
this result still valid in a political e-uilibrium/ $f not6 "hat are the implications for the dnamics
of the econom/
To ans"er these -uestions6 let us dene *b

, b+ as the interest rate in state b "hen the ne"

level of debt is b

*and the other policies are at the e-uilibrium level+. The elasticit of the interest
rate "ith respect to b

evaluated at the e-uilibrium level b

N b

*b+ in state b is:

-

*b+ N
.*b

, b+
.b

*b

, b+
. *1)+
This elasticit has a clear empirical interpretation since it measures the relationship bet"een t"o
observable variables6 debt and the interest rate. Aet us also dene -
g
*b+ as the elasticit of g "ith
respect to debt6 -
g
*b+ N
g(b)
b
b
g(b)
. #e have the follo"ing characteri7ation of the 8uler e-uation
in a political e-uilibrium:
Proposition 2. In equilibrium$
G1 -

*b
t
+I )*+,*b
t
+ N
_
1
0
_
G
n
&*G, #+ 1+
_
S*b
t+1
+ -
g
*b
t+1
+
_
)*+,*b
t+1
+,
*1L+
where S*b+ is a nonnegative function of debt&
This representation of the 8uler e-uation has a straightfor"ard interpretation that claries the
forces shaping the dnamics of scal polic. The left hand side is the marginal benet of debt:
b increasing debt b a unit6 ta. revenues can be reduced b a unit at t6 inducing a net "elfare
19
%n intuiti*e terms, the MCPF is the mar1inal monetar' compensation necessar' to compensate an a1ent for
a mar1inal increase in ta4 re*enues(
20
A formal anal'sis if the plannerEs problem is a*ailable from the authors upon re?uest( See also ;Cun1?*ist
and Sar1ent 6200>7 for the anal'sis of a similar problem in a model with no endo1enous 1rowth(
1L
gain e-ual to )*+,*b
t
+. This term is corrected b *1 -

*b
t
++ to account for the fact that the
government is not a price ta,er in the bond mar,et. #hen6 for e.ample -

*b
t
+ > 06 an increase in
debt implies an increase in the interest rate: the corresponding reduction in resources limits the
benet of an increase in b. The right hand side can be interpreted as the marginal cost of debt. An
increase in debt generates t"o eects: it reduces future resources *"ith a "elfare eect measured
b the rst term6 )*+,*b
t+1
++6 and changes the polic mi. b aecting policies *this second
eect is represented b the term
_
1
0
_
G
n
&*G, #+ 1+
_
S*b
t+1
+ -
g
*b
t+1
++

+. #hen policies are

chosen b a utilitarian planner6 the second eect is irrelevant: policies are al"as optimal6 so b
the envelope theorem6 a marginal change from the optimal level has no "elfare eect. Since in
the model described above policies are ine?cient6 ho"ever6 the change in the polic mi. induced
b b has a rst order impact that can not be ignored. The rst term of the right hand side
of *1L+6 therefore6 incorporates the political distortion. Mot surprisingl6 the si7e of the political
distortion depends on and
G
n
&*G, #+: the larger is 6 the more severe is political con>ict because
citi7ens internali7e little of the benet of local public goods provided to districts to "hich the do
not belongP the smaller is
G
n
&*G, #+6 the less the ruling coalition is forced to internali7e the "elfare
of the remaining districts. #hen N 0 and0or
G
n
&*G, #+ N 16 it is as if policies "ere chosen b a
utilitarian decision ma,er6 so the political distortion is 7ero.
21
Dn a balanced gro"th path debt gro"s at the same rate as income6 so b
t
remains constant at
b

. #e sa that balanced gro"th path is stable if there is a neighborhood of b

such that the debt

ratio b converges to b

for an initial state in the neighborhood. $n general it is hard to establish

analticall the properties of the e-uilibrium policies and of a stable stead state. $n the ne.t
sections "e "ill use propositions 1 and 2 to stud a calibrated version of the model numericall.
4o"ever6 in the reminder of this section "e can use *1L+ to sho" that6 in the model described
above6 political distortions are necessar to e.plain t"o stli7ed empirical facts about developed
countries and to characteri7e the ,e properties of the convergence path.
#e sa that a balanced gro"th path is regular if it stable and t"o conditions are met: *1+ debt
is positive on the path6 i.e. b

> 0P and *2+ the interest rate elasticit is positive at the stead
state: i.e.6 -

*b

+ > 0 *or .*b

, b+/.b

> 0 at b

+. !rom a theoretical point of vie" neither of these

t"o properties need to necessaril hold in e-uilibrium. There is ho"ever evidence that these t"o
21
9e obtain an interestin1 interpretation of 21>3 b' di*idin1 both sides b' 1 2bt3( The 1o*ernment acts as
a standard monopolistA debt is chosen to e?uali!e the mar1inal bene/t to the mar1inal cost of debt wei1hted b' a
standard markup factor that depends on the elasticit' of the demandA 1/ 21 2bt33(
1:
b
t
,b
t+1
MCPF(b)
MCPF(b)
Fig 2.A Fig 2.B
b
*
MCPF(b
*
)
( ) ( ) 0 1 1 1
1 1 ( ) ( )
t g t t
Q q b b MCPF b
n

+ + +
( | |

| (
\
G
( ) 1 ( ) ( )
t t
b MCPF b

1
( )
t
MCPF b
+
( ) 1 ( ) ( )
t t
b MCPF b

b
t
,b
t+1
!igure 2: The 8uler e-uation for G N # N n and # < n.
properties are satised in most economies.
22
$ndeed6 the are al"as satised in the calibrations
"e present in the ne.t section. #e sa that there is political con(ict in the econom if > 0 and
# < n. #e have:
Proposition 3. ) stable steady state is regular only if there is political con(ict&
The intuition behind 3roposition ) is illustrated b !igure 2. %onsider rst !igure 2.A
"here "e represent an e-uilibrium in an environment "ith no political con>ict *so
G
n
&*", #+ N 1
and0or N 0+. The red dotted line represents the left hand side of the previous e-uation6
*1-

*b++)*+,*b+P the blue solid line represents the right hand side6 )*+,*b

+.
23
#e have a
stable stead state "hen the blue solid line intersects the red dotted line from belo". At the stead
state6 )*+,*b
t+1
+ N )*+,*b
t
+6 so the onl "a to satisf the e-uilibrium condition is to have
-

*b

+ N 0: as it is apparent from *1)+6 in a regular econom this is possible onl if b

N 0 "hen
there is no political distortion *i.e. N 0 and0or
G
n
&*G, #+ N 1+. The onl "a to have b

> 0 on
the balanced path is to shift )*+,*b

+ Bdo"n"ard6C so that the intersection moves to the right.

As illustrated in !igure 2.& this is possible onl if
0
_
1
G
n
&*G, #++
_
S*b
t+1
+ -
g
*b
t+1
+ > 06 i.e.6
onl if there is a political distortion:
G
n
&*G, #+ < 1 and > 0.
22
The re?uirement of a positi*e le*el of debt at the stead' state seems natural( For e*idence on the interest
rate see, for e4ample, Arda1na, Caselli and ;ane 6200)7 and ;aubach 6200:7(
23
%n the Fi1ure, MCPF2b3 intersects the ori1in, but it is not necessar' to ha*e MCPF203 B 0( The actual
le*el of MCPF203 is irrele*ant for the anal'sis(
1<
$t is interesting to note that the positive interior level of debt in the model is the result
of t"o contrasting forces: on the one hand6 political econom distortions push debt upP on the
other hand6 the attempt to manipulate the interest rate pushes debt do"n. #e "ould not have
positive debt at the stead state "ithout the rst eectP "e "ould not have an interior level of
debt "ithout the second eect: politicians "ould al"as have an incentive to shift the nancing
of e.penditure to the future and accumulate more debt. At the stead state the t"o incentive
e.actl counterbalance each other.
The ne.t result characteri7es the dnamics of the public sector on the convergence path to a
regular stead state.
Proposition 4. *tarting from any b
0
in a left neighborhood of a regular steady state, both
infrastructure and the e+pected level of local public goods grow at a slower rate than ,-".
An interesting implication of 3roposition L is that despite the fact that in this econom the
polic'ma,er has e.cessive incentives to spend in local public goods6 the e.pected suppl of public
goods declines over time6 and so the public sector becomes smaller and smaller as a fraction of
123. This phenomenon is a conse-uence of the political distortion in the presence of endogenous
interest rates. As debt increases6 the proposer nds it optimal to increase the primar surplus b
reducing e.penditures rather than b increasing ta.es: reducing e.penditures rather than raising
ta.es forces up disposable income and savings6 and so it holds interest rates do"n. To the contrar6
an increase in ta.es forces do"n disposable income and savings6 and6 hence6 puts up"ard pressure
on the interest rate. 3roposition L sho"s that the legislators al"as nd it optimal to shrin,
the provision of public services *both in terms of public goods and infrastructure+. 4o"ever6 the
proposition does not establish that the nd it optimal to decrease ta.ation. This nding "ill be
established in the ne.t section "hen "e solve numericall a version of the model calibrated after
the U.S. econom.
#hat is the implication of this converging path for productivit/ #hen there is no learning'
b'doing6 this -uestion can be easil ans"ered.
Proposition 5. If
1
N 0, then starting from any b
0
in a left neighborhood of a regular steady
state, the growth rate in productivity Rz
t
/z
t
gradually declines on the convergence path&
!igure ) illustrates the last part of 3roposition L and 3roposition :. As b converges to b

infrastructure declines: in this case the gro"th rate of productivit *I+ shifts to"ards the L:
1Q
( )
t
I
( )
1 t
I
+
( ) I

45
o
z
t
z
t+1
z
t+T
z
z
!igure ): 1ro"th 2namics
degree line and z gro"s at a decreasing pace *or potentiall ma even decline if *I+ is lo"er than
one+.
3roposition : does not necessaril hold in the presence of learning'b'doing. The reason
is that the ta. rate ma decline on the transition path. $f this decline implies an increase in
labor suppl6 then "e have t"o forces pushing in opposite directions. A decline in the ta. rate6
ho"ever6 does not generall impl that labor suppl increases. The reason for this is that6 as debt
increases6 agents hold more nancial "ealth. The "ealth increase implies higher marginal utilit
for leisure: this ma more than counterbalance the eect of the decrease in ta.ation. $n the ne.t
section "e sho" that "ith J3F preferences labor suppl tpicall declines on the transition path6
so productivit is decreasing also "ith learning'b'doing.
" # calibrated solution o$ the model
".1 %ositive analysis
$n this section "e stud the model presented above b numerical methods6 calibrating it to the
U.S. econom. The ,e parameters describing preferences and technolog are chosen to minimi7e
the dierences bet"een the stead state values of the ,e aggregate variable predicted b the
18
model and the corresponding average values in the U.S. econom in the 2001'2010 period. These
variables include public spending6 public investment and debt6 as fractions of 123. $mplicit is
the assumption that scal variables have been6 on average6 at their balanced gro"th levels during
this time period. The details on the calibration are presented in the appendi.. #e "ill discuss
alternative scenarios in Section L.2 and :. #ith fe" e.ceptions that "e discuss belo"6 all of the
-ualitative results presented here are robust to specic details of the calibration.
!igure L sho"s that the model has no di?cult in achieving the calibration targets *note that
the ta. revenue0123 ratio is not e.plicitl targeted in the calibration+. !igure : describes the
dnamics of the model sho"ing the transition to the balanced gro"th path and compares it to the
data.
24
A number of interesting features of the e-uilibrium dnamics emerge.
!irst6 consistentl "ith the theoretical analsis of the previous sections6 in the model debt gro"s
faster than 123 during transition to"ard the balanced gro"th path. Although the empirical time
series are naturall more volatile6 the lo" fre-uenc behavior of scal variables appears consistent
"ith the U.S. evidence.
Second6 both ta. revenues and e.penditure in public goods and in infrastructure gro" slo"er
than 123 on the transition path. The numerical solution therefore reinforces the analtic results
presented in the previous section b sho"ing that not onl do e.penditures over 123 decline6
but the ta. revenues over 123 decline as "ell. This is the same shrin,ing government eect
discussed in 3roposition L. As debt increases6 the government has to increase the primar surplus
b either increasing ta.es or reducing e.penditures. Feductions in e.penditures6 ho"ever6 tend
to be more eective as the increase citi7ens= savings and6 hence6 reduce the e-uilibrium interest
rate. & reducing e.penditure the government rela.es the budget constraint in t"o "as: directl
b reducing e.pendituresP and indirectl6 b reducing the e-uilibrium interest rate. The eect of
an increase in ta.ation is dierent. 4igher ta.es reduce disposable income and therefore6 ceteris
paribus6 reduce savings and increase the e-uilibrium interest rate. As the stoc, of debt increases6
the interest rate eect becomes increasingl signicant6 ma,ing ta. increases even less attractive.
The third feature regards labor suppl and provides some insight about the mechanics of the
model. The right panel of !igure < sho"s that despite the reduction in ta.ation6 labor suppl
declines over time. This phenomenon is due to the fact that as debt increases6 households hold
24
%n our comparison of the model with the data we focus on the period from 1:)1 to 2010( 9e do not consider
earlier data because we would like to abstract from the conse?uences of 99%% and the 8orean 9ar, which had
si1ni/cant /scal impacts not related to the speci/c issues we are stud'in1 in this paper(
1H
Federal Debt
GDP
Public Goods
GDP
Public Investment
GDP
Tax Revenue
GDP
Data 40.4 9.4 0.9 10.3
Model 40.5 9.3 0.9 11.1
!igure L: %alibration.
increasing levels of "ealth to nance it: the "ealth eect increases the marginal utilit of leisure6
and reduces labor suppl. Eovements in labor suppl6 ho"ever6 are not particularl strong:
overall6 it declines b less than one percent over the L0 ear period.
The nal feature of the e-uilibrium sho"n b !igure < regards the gro"th rate: both produc'
tivit and income gro"th rates decline as the reach their stead state levels. This nding also
e.tends the results of the previous section b sho"ing that productivit and output gro"th decline
as the econom approaches the balanced gro"th path even in the presence of learning'b'doing
*at least in the calibrated solution+. The decline in gro"th is due to t"o factors: the decrease
in the investment in infrastructure b the government and the decrease in labor suppl due to
the "ealth eect. Since the ta. rate declines over time6 if "e did not have the "ealth eect to
,eep labor suppl do"n6 "e "ould have t"o contrasting eect: the decline in investment and the
increase in labor suppl due to the decline in .
#e can see the role plaed b political distortions b comparing the evolution of the scal
variables in e-uilibrium to the evolution "e "ould have in the same econom "ith no political
distortions * N 0 or # N n+. #ith no political distortions the stead state converges to a
7ero debt0123 ratioP on the transition path6 moreover6 "e observe that ta.es6 public goods and
infrastructure all increase over time: all of these predictions are in sharp contrast "ith the U.S.
e.perience in the last L0 ears. This discrepanc "ith the data does not depend on the calibration:
as "e ,no" from 3roposition )6 "ith no political distortions a 7ero debt0123 ratio is the onl
regular stead state.
$t is "orth emphasi7ing that the model is calibrated using onl average values of scal variables
over 2001'2010 period and standard F&% parameter values. 1iven such parsimonious parame'
teri7ation6 the model=s abilit to t lo" fre-uenc dnamics of the U.S. scal polic is6 perhaps6
20
1970 1980 1990 2000 2010
0
10
20
30
40
50
60
Public debt, % of GDP
1970 1980 1990 2000 2010
10
15
20
25
Taxes (net of SS contributions), in %
1970 1980 1990 2000 2010
10
15
20
25
(Total) Public good, % of GDP
Year
1970 1980 1990 2000 2010
1
1.5
2
2.5
Public Investment, % of GDP
Year


Model
No Pol. Distortions
Data
!igure :: !iscal 3olic 2namics: data6 political e-uilibrium6 and e-uilibrium "ith no political
distortions.
-uite remar,able. #e should also stress that modest response of the gro"th rates to the rise in
debt along the transition path is a conse-uence of our conservative calibration strateg. Mamel6
in the calibration the gro"th elasticit "ith respect to public investment is positivel related to
the specic denition of public investment used as target value.
25
!or the latter "e use a narro"
denition6 BFesearch and 2evelopmentC component of federal outlas. Using a broader measure6
such as BTotal $nvestment Dutlas for Ea5or 3ublic 3hsical %apital6 Fesearch and 2evelopment6
and 8ducation and TrainingC component of federal outlas "ould amplif the eect of political
econom distortions on the gro"th rates of productivit and output.
25
As we detail in Appendi4, the calibrated *alue of the parameter
1
is tin'A 0(001"1(
21
1970 1980 1990 2000 2010
3
2
1
0
1
2
3
TFP Growth, in %


Model
Data
1970 1980 1990 2000 2010
5
4
3
2
1
0
1
2
3
4
5
GDP Growth, in %
1970 1980 1990 2000 2010
8
6
4
2
0
2
4
6
8
Labor Supply, in %
!igure <: 1ro"th and Aabor Suppl 2namics
".2 &omparative statics
$n this section "e stud ho" the e-uilibrium changes as "e change the fundamentals of the
econom. #e focus on t"o ,e variables. !irst6 "e consider changes in the political con>ict in
the econom6 as measured b . As increases6 the con>ict bet"een districts increases because
citi7ens become less sensitive to public goods provided to constituencies to "hich the do not
belong. Second6 "e stud the role of "ealth eects in shaping e-uilibrium dnamics of the
econom. To this end6 "e stud a version of the model in "hich citi7ens decisions over labor
suppl are independent of their consumption0saving decision.
4.2.1 Political conict
!igure Q illustrates the eect of changes in from its baseline value of 0.:) to 0 *"here there are
no benets from pure local public goods+ on the balanced gro"th path values of the variables of
interest. The lo"er is the lo"er is political con>ict6 since preferences are more aligned.
Three ndings are "orth noting. !irst6 a lo"er level of political con>ict induces a lo"er stead
state level of debt. The level of debt relative to 123 indeed converges to 7ero as converges to
22
0 0.2 0.4
5
10
15
20
25
30
35
40
Public debt, % of GDP
0 0.2 0.4
22
24
26
28
30
32
Tax rate, in %
0 0.2 0.4
10
12
14
16
18
20
22
(Total) Public good, % of GDP
0 0.2 0.4
100
100.05
100.1
100.15
100.2
100.25

Labor supply
0 0.2 0.4
0
0.05
0.1
0.15

Growth rates, in %


Cumulative
Due to LBD
Due to g

0 0.2 0.4
1
1.2
1.4
1.6
1.8
2
2.2
2.4

Public investment, % of GDP

!igure Q: 3ublic 1ood 8.ternalit6 !iscal 3olic and 8conomic Dutcomes.
06 as discussed in Section ).
Second6 a decrease in political con>ict induces a higher level of investment in public infrastruc'
ture and local public goods. As decreases the proposer internali7es more of the benet of all
local public goods and he0she internali7es less of the benet of the local public good provide to
his0her o"n district. This reduces the political bias: indeed6 "hen N 0 the proposer chooses
policies in the same "a as a utilitarian decision ma,er.
The third eect is perhaps more surprising: a decrease in political con>ict induces an increase
in the ta. rate and it has a non'monotonic eect on labor suppl and gro"th. As decreases6
the ta. rate increases to nance higher provision of public good "ithout increasing debt *for the
reasons discussed in Section ).2+. As decreases6 stead state labor suppl initiall increases.
This phenomenon is due to the "ealth eect: the decrease in induces a decline in public debt
and6 hence6 in privatel held "ealth6 so it induces a decline in the marginal utilit of leisure as
2)
"ell. !or lo"er levels of 6 ho"ever6 the higher ta. rate tends to counterbalance the "ealth eect6
and labor suppl decreases in response to a decline in . Monetheless6 the eects of ta.ation and
"ealth roughl oset each other@the dierences in labor suppl across dierent =s do not e.ceed
0.2: percent.
The non monotonicit in labor suppl e.plains "h the gro"th rate is non monotonic in .
$t is important to stress that "elfare is monotonicall increasing in : hence6 the gro"th rate is
not necessaril a good measure of "elfare in this model. As political distortions are reduced6 the
public goods share of output increases: public goods increase "elfare6 but the do not increase
gro"th. The result is that "ith higher "e ma have more BconsumptionC in the form of public
goods6 but a lo"er gro"th rate. $n these situations6 the econom gro"s at a slo"er rate6 but it
has a superior balance *as measured b "elfare+ bet"een the private and the public sector.
Since debt is monotonicall decreasing in 6 the non monotonicit of the gro"th rate "ith
respect to ma e.plain "h there is evidence suggesting a non monotonic relation bet"een debt
and gro"th.
26
!igure Q suggests that "e should e.pect the relationship bet"een gro"th and
debt to be negative for countries "ith a high 6 and positive for countries "ith lo" .
4.2.2 ealth e!ects
As "e have described above6 "ealth eects pla an important role in the dnamics of the econom.
8ven "ith a declining ta. rate6 labor suppl declines over time because of the accumulation of
private "ealth necessar to nance the stoc, of public debt. To stud the role plaed b "ealth6
"e compute the e-uilibrium "ith an alternative utilit function in "hich "ealth eects are absent.
The comparison bet"een economies "ith and "ithout "ealth eect "ill help to better understand
the role of the "ealth eect on gro"th and the polic'ma,ing process.
To this end "e assume that the citi7ens= preferences are described b a version of 1reen"ood6
4erco"it7 and 4uman *1446 1H88+ utilit function. As is "ell ,no"n6 144 preferences need
to be ad5usted to be consistent "ith balanced gro"th path. #e do this in spirit of (aimovich and
Febelo *2008+. $n particular6 "e assume that the utilit function from consumption and labor is
26
For e*idence on the relationship between debt and 1rowth see, for e4ample, &einhart and &o1o5 620107, 8umar
and 9o 620107 and Checherita and &other 620107(
2L
given b
U*c
t
, l
t
+ N log
_
c
t
/
t
l
1+
t
1 O0
_
. *1:+
$n this denition the variable /
t
depends on aggregate *or average+ consumption and labor in
period t: the higher aggregate consumption is6 the higher is labor disutilitP the higher is aggregate
labor suppl6 the lo"er is labor disutilit. Eore precisel:
/
t
N
T / *T c
t
O T g
t
+
T
l
t
,
"here T / is a constant and the upper bar on the other variables indicates their respective average
values *"hich are ta,en as e.ogenous b the individual citi7ens+. !igure 8 illustrates the dnamics
of an econom calibrated in the same "a as in the baseline model. The behavior of scal variables
is ver similar to that described in the previous section "ith e.ception of ta.es. 4ere the ta. rate
decline is less pronounced. As before6 the gro"th rates decline over time *see !igure H+. Since
"ith 144 utilities "e do not have "ealth eects6 labor suppl is no" driven b the reduction in
ta.es6 and so it is increasing over time.
27
' Growth and austerity pro!rams
As the analsis of the previous section has highlighted6 the political e-uilibrium is ine?cient: it
leads to an e.cessive accumulation of debt relative to 123 and ma result in a lo"er than e?cient
gro"th rate. %an "e improve "elfare b forcing the government to run a larger primar surplus/
And if es6 ho" does the econom react to such an imposition/ Ans"ering these -uestion ma
help better understand the li,el eects on "elfare of austerit measures of the tpe passed b
the U.S. congress "ith the &udget %ontrol Act of 2011.
28
$n this section "e use the political
econom model described above to stud the eects of these tpes of programs and the "a the
should be designed. !irst6 "e consider a simple tpe of austerit program: starting from the
balanced gro"th path6 a countr is re-uired to permanentl reduce the debt to 123 ratio to a
target level 1 in T ears.
29
Second6 "e then rela. the assumption that the austerit program can
27
ote that dependin1 on the parameteri!ation, it is possible to ha*e positi*e 1rowth on the transition pathA
e(1(, shuttin1 down public in*estment in this e4ample will impl' that 1rowth depends onl' on learnin1$b'$doin1,
and hence increases as the debt rises(
28
The Bud1et Control Act of 2011 establishes o*er :00 billions in bud1et cuts in 10 'ears and tri11ers automatic
across$the board cuts in spendin1 if a de/cit reduction bill of at least 1(2 trillions is not passed b' Fanuar' 201<(
29
%n particular we assume that the le1islators are forced to reduce b b' a constant amount in e*er' period until
the new tar1et of debtDG-. is reached(
2:
1970 1980 1990 2000 2010
20
30
40
50
60
Public debt, % of GDP
1970 1980 1990 2000 2010
7
8
9
10
11
12
13
14
Taxes (net of SS contributions), in %
1970 1980 1990 2000 2010
7
8
9
10
11
12
13
14
(Total) Public good, % of GDP
Year
1970 1980 1990 2000 2010
0.6
0.8
1
1.2
1.4
1.6
Public Investment, % of GDP
Year


Model
Data
!igure 8: 144: !iscal 3olic 2namics
last forever: #e consider the case in "hich austerit can onl be imposed for a limited amount
of time6 after "hich legislators are free to choose scal polic "ith no constraints.
The e!ects o" an austerity plan #ith commitment. !igure 10 illustrates the evolution of
the e-uilibrium studied in the previous section "hen6 starting from the stead state6 the econom
is forced to reduce the level of debt relative to 123 b :0; of its current level in Q ears. #e
consider this plan because6 as "e "ill sho" belo"6 it is the optimal austerit plan for the specic
econom assumed in the calibration *the design of the optimal plan is discussed in greater detail
in the ne.t subsection+.
30
3erhaps not surprisingl6 after the introduction of the program the ta. rate and government
e.penditure in public goods and infrastructure respectivel spi,e up and do"n. There is ho"ever
30
%n the ne4t subsection we consider alternati*e calibrations of the econom'( All the ?ualitati*e feature of the
d'namics of the econom' after an austerit' pro1ram discussed here are robust to the speci/c calibration(
2<
1970 1980 1990 2000 2010
3
2
1
0
1
2
3
TFP Growth, in %


Model
Data
1970 1980 1990 2000 2010
5
4
3
2
1
0
1
2
3
4
5
GDP Growth, in %
1970 1980 1990 2000 2010
8
6
4
2
0
2
4
6
8
Labor Supply, in %
!igure H: 144: 1ro"th and Aabor Suppl 2namics
a ,e dierence in their reaction: the ta. rate ,eeps increasing for the entire period of the program
and it settles at a permanentl higher stead stateP b contrast6 public good provision dips belo"
the pre'program period stead state level for t"o ears6 it then recovers and ,eeps increasing until
the higher stead state is reached. $n the seven ears of the program6 the ta. rate increases b
L percentage points and total public e.penditure as a share of 123 increases b : percentage
points.
31
2uring the austerit program6 the gro"th rate of 123 remains belo" the pre'program
level b about 0.:;. &ecause of the fall in the gro"th in 1236 the debt0123 ratio initiall
increases6 but then it graduall falls until it reaches the ne" stead state.
The transition process e.hibits a number of interesting features. !irst6 as the econom con'
verges to"ard a ne" balanced path6 the gro"th rate is belo" its pre'program level. The gro"th
rate6 ho"ever6 is a poor measure of "elfare and a poor "a to measure the success of the program.
The last panel of !igure 10 illustrates the dnamics of the per period e.pected indirect utilit *i.e.
the e.pected value of *<++ scaled b productivit. %iti7ens= utilit initiall fall and remains belo"
the pre'austerit level for the rst L ears. After three ears6 ho"ever6 the per period indirect
31
The latter rises more than the former because the 1o*ernment has to pa' less interest on debt after the chan1e(
2Q
0 2 4 6 8
15
20
25
30
35
40
45
Public debt, % of GDP
0 2 4 6 8
21
22
23
24
25
26
27
Tax Rate, in %
0 2 4 6 8
8
9
10
11
12
13
14
15
(Total) Public good, % of GDP
0 2 4 6 8
97.5
98
98.5
99
99.5
100
100.5
Labor supply
Time Period
0 2 4 6 8
0.6
0.4
0.2
0
0.2
Time Period
Growth Rate, in %
0 2 4 6 8
0.05
0
0.05
Utility
Time Period
!igure 10: 8volution of the econom during the austerit program.
utilit starts increasing6 and it continues to increase until the end of the program.
The second interesting feature of the transition is that although the program imposes to run
a scal surplus6 the si7e of the public sector over 123 increases over time. This process is
the reverse of the shrinking government eect that "e have highlighted in the previous sections.
As "e have e.plained6 the endogeneit of the interest rate ma,es reduction in e.penditures a
more eective "a to increase the budget surplus than increases in ta.ation "hen debt is high a
reduction in e.penditure lo"ers the interest rate. As debt is forced to decline6 therefore6 this bias
in the polic mi. is reduced.
The optimal austerity plan. #e no" discuss ho" to chose the optimal austerit plan6 and ho"
it changes "ith the environment. !igure 11 compares the "elfare eects of alternative austerit
programs for the baseline calibration. The ro"s of the table list alternative target reductions in
28
Target Duration
Level 1 2 3 4 5 6 7 8 9 10 15 20
35 0.52 0.81 0.84 0.85 0.85 0.84 0.83 0.82 0.80 0.79 0.72 0.66
30 0.45 1.35 1.46 1.5 1.51 1.5 1.49 1.47 1.45 1.43 1.32 1.21
25 -0.50 1.56 1.81 1.92 1.95 1.96 1.96 1.94 1.92 1.9 1.77 1.64
20 -3.24 1.39 1.84 2.04 2.12 2.16 2.18 2.18 2.17 2.15 2.04 1.91
15 0.70 1.46 1.78 1.94 2.03 2.08 2.1 2.12 2.12 2.08 1.99
10 -0.69 0.51 1.01 1.27 1.43 1.53 1.61 1.66 1.7 1.79 1.79
5 -3.1 -1.28 -0.53 -0.12 0.14 0.33 0.48 0.60 0.70 1.02 1.2
0 -7.12 -4.4 -3.32 -2.69 -2.26 -1.94 -1.67 -1.45 -1.25 -0.53 -0.04
!igure 11: Aong term austerit programs. An entr in the table is empt "hen the corresponding
reduction in debt is unfeasible.
the debt relative to output. The columns of the table list alternative hori7ons of the program. The
entr /
ij
in column i and entr j is the e-uivalence variation associated to the austerit program
e.pressed as a percentage of consumption in each period.
32
T"o interesting observations can be
dra"n from this table. !irst6 e.cept for the cases in "hich the program is e.tremel ambitious
*both in terms of debt reduction and0or in terms of time hori7on+6 austerit is "elfare improving.
Second6 the eect of a program is neither monotonic in its si7e nor in its time hori7on. $f6 for
e.ample6 "e . the time hori7on at T N Q periods6 austerit implies a gain of 0.8); in per period
consumption for target level of ):; of 123P as "e reduce the target to 20; of 1236 the benet
increases to 2.18;P but for targets belo" 20;6 the benet declines6 reaching a negative value of
'1.HL; for a complete reduction of debt to 7ero. Similarl6 if "e . 1 at 20;6 achieving the goal
in one period is e-uivalent to a permanent reduction in consumption of ').2L;P achieving it in
Q periods induces a permanent increase in consumption b 2.18 percentP achieving it in 20 ears
induces an increase b 1.H1;.
32
%n particular, let c
t
, l
t
,
t
and c
t
,

l
t
,
t
be the path of consumption, labor and public 1oods pro*ided before and
after austerit' pro1ram ij implemented at t
0
( The *ariable x
ij
is is chosen so that

t=t
0

t
6u2c
t
21 G x
ij
3, l
t
,
t
37
is e?ual to

t=t
0

t
u2c
t
,

l
t
,
t
3(
2H
The fact that an austerit program forcing fast debt repament improves "elfare ma appear
surprising at rst sight. Although the debt level is ine?cientl high at the e-uilibrium stead
state6 it ma appear that the best "a to pa it bac, is 5ust to evenl spread its cost over time b
servicing its cost and ,eeping the principal constant. To see "here the problem "ith this reasoning
is6 "e should note that although at the stead state the legislators ,eep policies constant6 the polic
mi. is ine?cient. !irst6 political distortions induce a biased distribution of e.penditures to"ard
local public goods for the districts of the ruling coalitionP second6 the lac, of commitment induces
legislators to use scal polic to ,eep the interest rate ine?cientl lo". !orcing legislators do run
a primar surplus is not directl benecial because it reduces public debtP it is benecial because it
induces them to change the polic mi.. This could be seen b comparing the e-uilibrium stead
state b

"ith the stead state that "ould be reached b a benevolent planner "ith commitment
*the rst best+ and "ith the stead state reached after the austerit plan6 in both cases starting
from b
0
N b

.
33
The benevolent planner "ould increase the ta. rate from the e-uilibrium stead
state level from 21.1; to ):.);6 g from H.); to 2).);6 and I from 0.H; to 2.L;. $mposing the
austerit plan at b

does not induce such a large long term change in the polic mi.6 but it brings
it closer to this optimal levels6 inducing the intermediate levels N2:.2;6 gN1L.2; and IN1.L;.
4o" does the design of the optimal austerit program depend on the stead state level of debt
before the plan is implemented/ $n the baseline calibration presented above the parameters are
chosen so that the stead state level of debt0123 is L0.:;. !igure 12 illustrates alternative
calibrations "ith higher values 6 the measure of the e.ternalit and therefore of the political
con>ict in the econom *and ,eeping all the remaining parameters constant+. !or each level of
6 the corresponding ro" illustrates the ,e variables of the ne" political e-uilibrium: the rst
column sho"s the stead state level of the debt'to'123 ratio "ith no austerit planP the follo"ing
t"o columns describe the associated optimal austerit program in terms of its time hori7on and
nal debt0123 target *calculated assuming the econom starts at the stead state level of debt+.
!igure 12 illustrates that there is no Bone'si7e'ts'allC optimal austerit program. As increases6
and therefore the stead state level of debt0123 increases as "ell6 the time hori7on of the optimal
program becomes longer and the target level less demanding6 ranging from a debt to 123 level
of 20.1 for the benchmar, econom *"ith N .:)+ to a target of 2:.Q for an econom in "hich
33
The computation of the stead' state when policies are chosen b' a bene*olent planner with commitment is
omitted to sa*e space( The details are a*ailable from the authors(
)0
Value Implied SS of Optimal Austerity Measure
of debt/GDP ratio Years Target Level
.53 40.5 7 20.1
.55 47.0 9 20.3
.57 55.7 9 22.8
.59 63.1 10 23.7
.61 70.1 10 24.5
.62 78.9 11 25.7
!igure 12: Dptimal austerit for dierent =s.
is .<2. Mote that even though the target level increases "ith 6 the eective amount of debt
reduction also increases in . $n other "ords6 as increases6 even though the target level of debt
increases6 the optimal austerit program re-uires larger debt reductions.
$o commitment. The assumption that the austerit plan can induce a permanent reduction
in debt is ver strong: it is perhaps more realistic to assume that austerit can be imposed onl
for limited period of time6 after "hich legislators are free to choose policies "ith no constraints.
!igure 1) illustrates the eect of reducing debt to 20; of 123 *from a stead state of L0.:;+ in :
earsP at the end of the :th ear the program is terminated and so legislators return to the political
e-uilibrium.
34
As it can be seen from the gure6 the program induces onl a temporar eect
on policies6 that then return to the original stead state "hen the program is terminated. !igure
1L illustrates the "elfare eects of alternative austerit programs of this tpe. $t is interesting
to note that even "ith a limited commitment of 2': ears6 an austerit program that is not too
ambitious can improve "elfare. This is due to the fact that after the end of the program6 the
e-uilibrium converges to the *ine?cient+ stead state onl graduall6 so policies remain closer to
the rst best for a period that is much longer than the length of the program. The benet of
a temporar austerit programs6 ho"ever6 are uniforml much smaller than the benets achieved
"ith programs "ith commitment presented in !igure 116 and are never higher than 1; of per
34
=b*iousl', we assume that the len1th of the pro1ram is rationall' anticipated b' the le1islators, who therefore
take into account the temporar' nature of the pro1ram in choosin1 the policies(
)1
0 10 20
15
20
25
30
35
40
45
Public debt, % of GDP
0 10 20
21
22
23
24
25
26
27
28
Tax Rate, in %
0 10 20
8
9
10
11
12
13
14
15
(Total) Public good, % of GDP
0 10 20
96
97
98
99
100
101
102
Labor supply
Time Period
0 10 20
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
Time Period
Growth Rate, in %
0 10 20
0.06
0.04
0.02
0
0.02
0.04
0.06
Utility
Time Period
!igure 1): 8volution of the econom during the austerit program.
period consumption.
( &onclusion
This paper develops a political econom theor of gro"th and scal polic. $n the theor6 the
gro"th rate of the econom depends on public investment and6 through learning'b'doing6 on
labor suppl. !iscal polic aects citi7ens= incentives in t"o "as: ta.ation distorts labor suppl
and decits distort consumption0savings decision through their eect on the interest rate. 3olic
choices are made b a legislature consisting of elected representatives. 3olitical con>ict arises
because representatives in the legislature have incentives to vote for policies that favor their o"n
constituencies and citi7ens benet onl partiall from local public goods provided to constituencies
to "hich the do not belong.
)2
Target Duration
Level 1 2 3 4 5
35 -0.04 0.29 0.34 0.37 0.39
30 -0.58 0.39 0.54 0.63 0.68
25 -1.89 0.29 0.59 0.76 0.85
20 -4.88 -0.02 0.50 0.76 0.91
15 -0.56 0.26 0.64 0.85
10 -1.38 -0.15 0.38 0.68
5 -2.55 -0.76 -0.03 0.35
0 -4.18 -1.60 -0.64 -0.14
!igure 1L: Short term austerit programs. An entr in the table is empt "hen the corresponding
reduction in debt is unfeasible.
The model predicts that the econom converges to a balanced gro"th path in "hich consump'
tion6 public investment6 public good provision6 public debt and productivit gro" at the same
constant rate. The transition to the balanced gro"th path is characteri7ed b "hat "e call the
shrinking government eect: public debt gro"s faster than 1236 provisions of public goods and
infrastructure gro" slo"er than 123 and the ta. rate declines. These ndings are consistent "ith
the U.S. e.perience over the past fe" decades6 both from a -ualitative point of vie" and6 in our
calibrated solution6 from a -uantitative point of vie".
#e use the model as a laborator to stud the impact of a simple Bausterit programC in
"hich a countr is re-uired to bring do"n the debt0123 ratio. #e sho" that austerit programs
ma be used to limit political distortions and increase "elfare. The analsis ho"ever sho"s that
there is no Bone'si7e'ts'allC optimal austerit program: the higher is the accumulated level of
debt6 the less aggressive the optimal program should be *in terms of both the debt target to
reach and timing+. The analsis also sho"s that the gro"th rate and the short term dnamics of
debt0123 are poor measures of "elfare and a poor "a to measure the success of the program.
Dn the transition path of the optimal austerit program6 gro"th is belo" the pre'austerit level6
but "elfare is increasing.
))
There are man dierent directions in "hich the ideas presented here might usefull be devel'
oped. To focus on public policies6 "e have made a number of simplifing assumptions both on
the description of the econom and on the political process: there is no private capital6 no shoc,s6
"e are restricting attention to a smmetric econom "ith no redistribution6 and "ith a relativel
simple political decision ma,ing process. 8.tending the model to rela. these assumption "ould
certainl provide a richer frame"or, for analsis and improve the model=s predictive abilit. #e
are condent that these assumptions can be rela.ed in future research.
)L
)e$erences
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Eechanism6C )merican 2conomic #eview, H2*:+6 pp. 1LH8'1:20.
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2ra7en6 A. and K. 1rilli6 1HH). BThe &enet of %rises for 8conomic Feforms6C )merican
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&oom in the 1HH0s6C )merican 2conomic 1ournal$ 'acroeconomics, 26 pp. 88@12).
Meville6 !. and K. A. Fame6 200H. BEeasures of per %apita 4ours and Their $mplications
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'acroeconomics, Kol. 126 $ss. 16 (ul 2012.
)<
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2conomic *tudies6 vol. <0*L+6 pp. Q::'Q<.
3ersson6 T. and S. Svensson. 1H8H. B#h a Stubborn %onservative #ould Fun a decit:
polic "ith Time'inconsistent 3references6C .he /uarterly 1ournal of 2conomics6 10L:)2:'
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3ersson6 T. and 1. Tabellini6 1HHL. B$s $ne-ualit 4armful for 1ro"th/C )merican 2conomic
#eview6 vol. 8L*)+6 pp. <00'<21.
Febelo6 S. T.6 1HH1. BAong'Fun 3olic Analsis and Aong'Fun 1ro"th6C 1ournal of "olitical
2conomy6 vol. HH*)+: pp. :00':21.
Feinhart6 %. E. and J. S. Fogo6 2010. B1ro"th in a Time of 2ebt6C M&8F #or,ing 3aper
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Fogers6 %.6 1H8H. B2ebt restructuring "ith a public good6C *candinavian 1ournal of 2co0
nomics6 H16 pp. 11Q@1)0.
Saint'3aul6 1. 2001. BThe 2namics of 8.clusion and !iscal %onservatism6C #eview of
2conomic -ynamics6 vol. L*2+6 pp. 2Q:')02.
Saint'3aul6 1. and T. Kerdier6 1HH). B8ducation6 democrac and gro"th6C 1ournal of -e0
velopment 2conomics6 vol. L2*2+6 pp. )HH'L0Q.
Shin6 9.6 200<. BFamse Eeets &e"le: Dptimal 1overnment !inancing "ith $ncomplete
Ear,ets6C Eimeo.
Sto,e6 M. A. and F. 8. Aucas (r.6 1H8). BDptimal !iscal and Eonetar 3olic in an 8conom
"ithout %apital6C 1ournal of 'onetary& 2conomics, 126 pp. ::'H).
Sto,e6 M. A. and S. T. Febelo6 1HH:. B1ro"th 8ects of !lat'Fate Ta.es6C 1ournal of
"olitical 2conomy6 Universit of %hicago 3ress6 vol. 10)*)+6 pp. :1H':0.
)Q
* #ppendi+
$n this appendi. "e rst detail the statements and propositions presented in Sections 2 and ). #e
then discuss our data sources and the calibration presented in Sections L and :. As a preliminar
result6 "e start sho"ing that the citi7ens= indirect utilit functions can be represented as in (8)&
Lemma %1. .he per period indirect utility function is given by (8) where
U*p
t
+ N log
_
_
_n
0

*1
t
+
1+
0
_
1
1
n
_
I
t
O

j
g
j
t
_
_
1+
_
_
1

_
1
1
n
_
I
t
O

j
g
j
t
__
O1
t
_
_
1++
0
_
_
_
*1<+
Proo". The second term of *1+ can be "ritten as u*c
t
, l
t
, g
t
+ N log *c
t
*1 l
t
+

*nz
t
l
t
+

0
+ O

0
log
_
_
g
i
t
_

j
g
j
t
_
1
_
. Substituting *L+ and *:+ "e have the result.
#e ne.t provide the proof of Aemma 1.
*.1 %roo$ o$ ,emma 1
A citi7en6 "hose district is in the government6 has the follo"ing e.pected continuation value:
%
G
*b, z+ N U*p+ O2
0
3log
_
_
g
i
_

j
g
j
_
1
_
O%*b

, z

+.
4ence6 the incentive compatibilit constraint holds e-ualit i 3log g
i
N log g
c
. Since
3log g
i
N
1
G
_
log g O*# 1+ log g
c
O*G #+ log g
_
.
it must be the case that g
c
N g
1
Gq+1
g
1
1
Gq+1
, as stated.
*.2 %roo$ o$ %roposition 1
#rite %
t
N

=t

t
u*p

, z

+ as:
%
t
N

=t

t
_
*1 O
0
+ log z

OU*p

+ O
0
3log
_
_
g
i

j
g
j

_
1
__
Since log*z
t+1
+ N log*z
t
+ O
1
log *I
t
+ O
1
log l
t
Olog
0

0
n
1
6 "e have:
log*z
t+T
+ N log z
t
O

t+T1
=t
_

1
log *I

+ O*
1
O
1
+ log l

Olog
0

0
n

Using this formula and *L+'*Q+6 "e can e.press %

t
as
)8
%
t
N
1 O
0
1
log z
t
O
O

=t

t
_

_
U*p

+ O
(1+0)
1
_

1
log *I

+ O*
1
O
1
+ log l

Olog
0

0
n

O
0
3log
_
_
g
i

j
g
j

_
1
_
_

_
,
"hich6 in turn6 using the e.pression for 3log g
i
can be "ritten as
%
t
N Alog z
t
O

j=t

jt
_
U*p
t
+ O
0

G
n
&*G, #+ log g
t
_
,
"here A N
1+0
1
and
U*p
t
+ N (
0
OU*p
t
+ O
*1 O
0
+
1
G
1
log *I
t
+ O*
1
O
1
+ log l
t
I *1Q+
O
0
*1 + log
_
g
t
O*# 1+g
Q(G,q)
t
g
(1Q(G,q))
O*n #+g
_
,
"ith (
0
N
(1+
0
)
1
log
_

0
n
1
_
O
0
_
G
n
Gq
Gq+1
O
nG
n
_
log g.
$f "e dene V
t
N

=t

t
_
U*p

+ O
0
G
n
&*G, #+ log g

or6 in a recursive form6

V
t
N U*p
t
+ O
0

G
n
&*G, #+ log g
t
OV
t+1
*18+
condition *1Q+ can be "ritten as %
t
N Alog z
t
O V
t
. The e.pected value of a citi7en "ho ,no"s
to be a government formateur %
p
t
can be represented in the same. The onl dierence is that
the proposer receives log g
t
for sure instead than 3log
_
_
g
i
t
_

j
g
j
t
_
1
_
. As it can be easil
proven6 "e have:
%
p
t
N Alog*z
t
+ OU *p
t
+ O
0
log g
t
OV
t+1
. *1H+
"here V
t+1
is dened b *18+.
The proof of the proposition no" follo"s immediatel. Since Alog z is a constant6 if p*b+
solves *12+ given V*b+6 then it must be an optimal reaction function given the true value function
Alog*z+ O U *p+ O
0
log g O V*b

+P moreover if V*b+ satises *11+ given p*b+6 then %*b, z+ N

Alog z OV*b+ is the e.pected value in the game. Dn the contrar6 if p*b+ is an e-uilibrium6 then
"e must have %*b+ N Alog z OV*b+ and the proposer must ma.imi7e *12+.
*.3 %roo$ o$ %roposition 2
$t is rst convenient to dene the marginal cost of public funds *described informall in Section
)+. Aet 1*b, p+ N *b, p+ Gb O"*g+ OI OT nl*p+I. !rom the proposer=s budget constraint
)H
in *12+6 "e have

N z1*b, p+. $n order to reduce nominal debt

b one marginal unit the

re-uired increase in ta.es must be 4 N Gz1

*b, p+I
1
. The net marginal reduction in utilit
b an increase in ta.es is given b V

*b, p+6 "here V is the indirect utilit function dened in

*11+.
35
The reduction in utilit in absolute value is therefore
V(b,p)
zB(b,p)
. Eoreover the marginal
utilit of consumption is
1
zc(p(b))
. The marginal cost of public funds6 then is:
c(p)V(b,p)
B

(b,p)
. Mote
that the Aagrangian multiplier 5 from *12+ can be "ritten as: 5*b+ N
V(b,p)
B (b,p)
. #e conclude
that the marginal cost of public funds "hen policies are p and the Aagrangian multiplier is 5 is
)*+,*b+ N 5*b+c*p+.
#e no" prove *1L+. %onsider the rst order condition "ith respect to b

of *12+:
5*b+!*p+
*b, p+
_
1
b

*b, p+
.*b, p+
.b

_
N V

*b

+,
#e have
5*b+!*p+
*b, p+
*1 -

*b++ N V

*b

+, *20+
"here -

*b+ is the elasticit of the interest rate as dened in *1)+. Aet V

p
*b+ be the ob5ec'
tive function of *12+. Adding and subtracting
0
log *g*b++6 "e can "rite: V*b+ N V
p
*b+ O

0
_
G
n
&*G, #+ 1+
_
log g*b+. !rom the envelope theorem applied to *12+6 at an point of dier'
entiabilit "e have V

p
*b+ N 5*b+6 so "e can "rite:
V

*b+ N 5*b+ O
0
_
G
n
&*G, #+ 1+
_
.g*b+/.b
g*b+
. *21+
Using *20+ and "e have:
*1 -

*b++
5!*p+
*p+
N 5*b

+
0
_
G
n
&*G, #+ 1+
_
.g*b

+/.b

g*b

+
. *22+
Dbserve no" that *Q+ can be "ritten as: *b, p+ N c*p*b

++!*p+/c*p+. #e can therefore "rite:

*1 -

*b++ c*p+ 5*b+ N c*p*b

++ 5*b

+
_
1
1
5*b

0
_
G
n
&*G, #+ 1+
_
.g*b

+/.b

g*b

+
_
*2)+
2ene: S*b

+ N 1/ *b

5*b

++6 and let -

g
*b

+ N
g(b

)
b

g(b

)
be the elasticit of g*b

+ "ith respect to
b

. Using the fact that )*+,*b+ N 5*b+c*p+6 "e obtain *1L+.

35
The indirect utilit' is e*aluated at the e?uilibrium polic' p2b3, where b is the state( For simplicit' we omit
the state form the e4pression of the polic' when it does not create confusion(
L0
*." %roo$ o$ %roposition 3
$f G N # N n and0or N 0& "e have
_
1
G
n
&*G, #++
_
N 0. $n this case6 at the stead state b

"e must have:

(b

,b

)
b

(b

,b

)
N 06 "here the derivative is evaluated at b

. Since )*+,*b

+ > 0
and
(b

,b)
b

> 0 at b N b

6 a stead state is possible onl if b

N 0.
*.' %roo$ o$ %roposition "
$n a regular stead state b

"e have:
-

*b

+ N
0
_
1
G
n
&*G, #++
_
S*b

+ -
g
*b

+. *2L+
"here -

*b

+ > 0 and S*b

+ > 0. #e conclude that -

g
*b

+ < 0 and so g*b+ is decreasing in b in

a neighborhood of the stead state in an smooth e-uilibrium. Since the stead state is stable6
starting from b
0
in a left neighborhood6 b
t+1
> b
t
6 and so
t+1
/
t
< y
t+1
/y
t
for an t > 0. &
Aemma 16 "e must have and
c
t+1
/
c
t
< y
t+1
/y
t
6 "here
c
t
N g
c
t
y
t
is the dollar value of public
goods allocated to the districts in the minimal "inning coalition. !rom the rst order conditions
of *12+ it is also eas to sho" that I
t
is monotone in g
t
6 so "e have I
t+1
/I
t
< y
t+1
/y
t
as "ell.

*.( -ata and &alibration

'ata $n this section "e provide information on the sources of the data used to construct !igures
16 L6 : on the U.S. econom. #e also brie> discuss the statistical signicance of the trends
illustrated in the !igures.
2ata on output and the ta. revenue'to'123 ratio is obtained from &8A=s Mational $ncome
and 3roduct Accounts (M$3A6 Tables Q.1 and 1L.26 respectivel+.
36
Ta. revenues are measured
net of Social Securit contributions. 2ata on productivit is obtained from (ohn !ernald=s series
on utili7ation ad5usted T!3 based on &asu6 !ernald and Jimball G200<I.
37
Aabor suppl data
is from Meville and Fame G200HI. 2ata on debt is ta,en from the U.S. D?ce of Eanagement
and &udget6 *Table Q.1+.
38
!or public goods "e use the U.S. D?ce of Eanagement and &udget
36
A*ailable at http://www.bea.gov/iTable/index nipa.cfm
37
A*ailable at http://www.frbsf.org/economics/economists/sta.php?jfernald(
38
A*ailable at http://www.whitehouse.gov/omb/budget/Historicals).
L1
*Table ).1+.
39
Dur denition of public investment comes from !ederal Dutlas6 M$3A6 Table H.1.
#e have loo,ed at t"o measures: BFesearch and 2evelopment6C and BTotal $nvestment Dutlas
for Ea5or 3ublic 3hsical %apital6 Fesearch and 2evelopment6 and 8ducation and Training.C $n
our baseline calibration "e conservativel use the former.
Dver the period of 1HQ1'2010 "e observe that !ederal debt *as a fraction of 123+ sho"s
positive statisticall signicant time trend. 3ublic goods *as a fraction of 123+ sho" negative
statisticall signicant time trend. This fact is robust to the inclusion0e.clusion of 4ealth and to
inclusion0e.clusion of Mational 2efence in the denition of public goods. 3ublic investment *as a
fraction of 123+6 dened either "a6 sho"s negative statisticall signicant time trend. This fact
is robust to the inclusion0e.clusion of the defence share. Ta. revenues *as a fraction of 123+6
sho" negative statisticall signicant time trend.
)alibration The ,e parameters describing the fundamentals $, 0 and are chosen follo"ing
the F&% literature. #e choose log'utilit function for consumption "ith $ N 1 as in (aimovich
and Febelo G2008I and Ec1rattan and 3rescott G2010I. #e set N 1.)Q, "hich ields labor
elasticit of about 1.: at the stead state of the model and is in a mid'range of the parameters
used in the literature. #e set to 0.H:L6 so that "e match the real interest rate of <; *(aimovich
and Febelo6 G2008I+. The literature provides no guidance on the *long'run+ elasticit of gro"th
via A&2. #e set it to N 0.2L:. That is6 "e assume that the long run elasticit of the A&2
"ith respect to labor is three -uarters of its short run elasticit6 as estimated b %hang et al.
G2002I. The transfer parameter is set to its empirical counterpart6 10; of 123. The parameters
describing the political process are n6 G, #6 and g. #e set the number of districts to 1006 the
government si7e6 G6 to 1006 the ma5orit re-uired to pass the legislation to :16 and g to .01: 1;
of output of a single district. The e.act number of districts6 the government si7e6 and the si7e
of the minimal "inning coalition are not particularl relevant in absolute terms6 "hat matters is
the ratio
G
n
&*G, #+. $n the standard calibration it is therefore set to :1;. The ratio g is also not
particularl important for the results: "e have done e.tensive sensitivit analsis obtaining ver
39
9e use the followin1 classi/cation of Federal =utla's, as reported b' the =Hce of Mana1ement and Bud1etA
.ublic Goods: 2i3 ational -eferenceI 2ii3 #ducation, Trainin1, #mplo'ment and Social Ser*icesI 2iii3 Jealth, 2i*3
#ner1'I 2*3 ational &esources and #n*ironmentI 2*i3 TransportationI 2*ii3 Communit' and &e1ional -e*elopmentI
2*iii3 %nternational A5airsI 2i43 General Science, Space and Technolo1', 243 A1ricultureI 24i3 Administration of
FusticeI 24ii3 General Go*ernmentI 24iii3 Keterans Bene/ts and Ser*ices( TransfersA 2i3 MedicareI 2ii3 %ncome
Securit'I 2iii3 Social Securit'I 2i*3 Commerse and Jousin1 Credit( =therA et %nterest(
L2
similar results.
40
The remaining parameters are chosen to t the ,e moments. $n particular6 "e
choose ,
0
and
1
to match the debt'to'123 ratio6 the share of total public good and investment
in 123. This ields values of 0.:)6 0.LH and 0.001816 respectivel.
40
#(1(, increasin1 or decreasin1 it b' a factor of two lea*es the ?uantitati*e results of the paper *irtuall'
unchan1ed(
L)