Intergenerational Allocation of Government Expenditure, Externalities and Optimal Taxation

Abstract

In this paper we argue that government's allocation of resources among competing age groups has significant bearing on labor and capital supply and optimal tax policies. Empirics reveal that allocation of public expenditure is highly favorable to the old cohorts in developed countries. However, we don't know whether this allocation is socially optimal. In this study, we develop a suitable framework of two period lived OLG with endogenous labor supply in both periods to derive the socially optimal level of public expenditure on the young and the old for two cases: i) public spending is only utility enhancing and ii) public spending is both utility and labor productivity enhancing. This study underscores the importance of the allocation of public expenditure between different age groups and sheds light on the factors that determine socially optimal public allocation between the young and the old. We also examine how labor, capital and optimal tax rates change when spending on the young and the old deviates from the socially optimal level. The results on optimal taxes also highlight the implications of life cycle economy. Tax deductions, exemptions etc., that make labor income tax different across age cohorts, are optimal if consumption tax is not uniform across cohorts. These cohort specific consumption taxes also create distortion in the intertemporal margin, resulting in non-zero capital income tax in the long run.