Public debt and income inequality in an endogenous growth model with elastic labor supply

Abstract

In this study, we examine the relationships among long-run public debt policy, economic growth, and income inequality by extending a representative consumer theory of distribution and using an endogenous growth model with a sustainable fiscal rule, elastic labor supply, and initial endowment of heterogeneous wealth. We show that fiscal policy with strict (loose) budgetary discipline decreases (increases) the economic growth rate in the short run. In contrast, it increases (decreases) the economic growth rate in the long run. Then, we show that fiscal policy with strict (loose) budgetary discipline decreases (increases) income inequality in both the short and long run. First, we show that a balanced growth path is a locally stable saddle point. Then, we consider the relationships among public debt, the economic growth rate, and income inequality. In this model, the average leisure and the public-debt-to-private-capital ratio determine the rate of return and wage rate, affecting both the economic growth rate and income distribution across agents. We conclude that there is a negative relation between the economic growth rate and the measure of income inequality in the long run by conducting numerical simulations using US data. The policy implication of this paper is that the government has a public debt policy that achieves both faster economic growth and the improvement of income inequality.