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Abstract
This paper considers an endogenous growth model with public capital and government debt. In setting the level of public investment each period, the government is assumed to follow two commonly used in the growth literature fiscal rules: public investment is either equal to a constant fraction of output or equal to a constant share of tax revenues. In our model, we allow revenues to be raised by the government through progressive income taxation and bonds issue. For both fiscal rules, we show that the potential occurrence of either indeterminacy or instability crucially depends on whether the government is a debtor or a creditor. In particular, government indebtedness causes the economy to be prone to either belief-driven aggregate fluctuations or unstable dynamics. This is a novel result in the related literature which has largely overlooked the role of public debt as a possible contributing factor to the presence of indeterminacy and instability in growth models.
Highlights
This paper studies the relationship between public debt and macroeconomic stability in the context of a representative agent model of endogenous growth
The present paper analyzes the possibility of local indeterminacy when it is fiscal policy that generates externalities leading to long-run growth
Guo and Lansing (1998) show in the context of the exogenous growth neoclassical model that a sufficiently progressive income tax schedule can ensure saddle path stability and stabilize the economy against sunspot fluctuations. Extending their framework in an endogenous growth setting, Chen and Guo (2013a) find that raising the tax progressivity may destabilize the economy with fluctuations driven by agents’ self-fulfilling expectations. In contrast to both studies, we find that the degree of progressivity of the tax schedule does not make the economy more or less susceptible to indeterminacy
Summary
This paper studies the relationship between public debt and macroeconomic stability in the context of a representative agent model of endogenous growth. The present paper analyzes the possibility of local indeterminacy when it is fiscal policy that generates externalities leading to long-run growth. We consider an endogenous growth model with public capital, progressive income taxation and government debt. Relative to the existing literature, our framework incorporates simultaneously two important features of actual fiscal policy: public debt and progressive taxation As it is discussed below when reviewing the related literature, indeterminacy appears to be quite prevalent in growth models with a government that maintains a balanced budget in every period and uses flat rate taxes to raise revenues. The economy may follow a dynamic path that violates the ANGYRIDIS, TSINTZOS Public Investment and Debt principles of intertemporal optimization or present value budget constraints For this reason, these outcomes are rendered in the related literature as infeasible. Appendix B presents an extended version of our model
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