The political economy of fiscal deficits and government production

Abstract

This paper studies how disagreement over which goods government should provide affects resource allocation in the public sector. An incumbent combines pre-determined capital with labor to produce different goods in the current period, and accumulates physical and financial capital for future production. Capital-labor complementarity determines how anticipated political turnover shapes governments' choice between saving in physical capital or financial assets. Turnover tends to render the stock of physical capital for public production too low and inefficiently combined with labor. The main cost of political turnover is production inefficiency in the public sector, not a suboptimal savings level.