Demand For Debt Research Articles

Fiscal Policy, Inflation and the Accumulation of Risky Capital

The effect of government policies on the level of investment and inflation has become a major concern of policy-makers in a number of industrial countries. Proposals to raise the level of business investment have included overall tax cuts, tax incentives to spur investment and a reduction in the level of government spending. This paper presents a theoretical apparatus to explore the relationships between fiscal policy, government debt, inflation and capital accumulation. It develops a one-sector growth model embodying a stochastic production function and government fiscal policy. Atomistic agents in the economy choose consumption levels and allocate their wealth between risky capital and risky government to maximize expected discounted utility over an infinite horizon. Fiscal policy, by affecting asset yields, affects the composition of portfolios, the price of government bonds and the accumulation of capital. The model is used to answer three general questions: (1) Does the level of government expenditure affect the rate of capital accumulation and inflation in steady state? (2) Does the mode of government finance, when the choice is between an income tax and deficit finance, affect these magnitudes? (3) What is the effect of uncertainty in the productivity of capital on growth? The analysis relates to several areas of literature: (1) the analysis of the relationship between capital accumulation and debt, (2) the theory of the demand for government debt, (3) considerations of the effect of income taxation on risk bearing, and (4) the analysis of capital accumulation under uncertainty. 1. The effects on output and the capital stock of the government's expenditure decision and its decision to finance its expenditure by taxation or issue are explored in two major bodies of economic theory. The literature on the burden of the debt as developed by Modigliani (1961), Diamond (1965), and Phelps and Shell (1969), for example, implies that policies which increase the value of outstanding government will tend to lower the level of the capital stock by displacing capital with public in private wealth. The theory of money and growth as represented by Tobin (1965) and Sidrauski (1967b) also implies that government displaces capital, but specifically recognizes the role of capital gains on government debt.

A Life-Cycle Model of the Linear Income Tax

Although an income tax is often a government's most important instrument for raising revenue and redistributing income, its potential usefulness for either of these purposes is limited by its negative impact on work incentives. The implications of the incentive effect have been studied by examining optimal tax structures under a variety of assumptions about preferences, the distribution of wage rates, and the form of the social welfare function. Much of this work has been done using models that include interpersonal variation in ability (wage rates), but in which no saving or dissaving occurs, i.e. in which the consumption of each individual is exactly equal to his labour income net of taxes within the time period (Mirrlees (1971), Sheshinski (1972a), (1972b), Atkinson (1973a), (1973b), Phelps (1973), Cooter and Helpman (1974), Itsumi (1974), Sadka (1976)). While the latter assumption might be innocuous if wage rates were approximately constant over an individual's lifetime, so that there was little incentive to borrow or save, or if capital markets were non-existent, so that borrowing and saving were impossible, wage profiles are in fact quite steep and most individuals make use of (admittedly imperfect) capital markets. Multiperiod models incorporating consumption-saving decisions have been used to study the effects on capital accumulation of wage, interest, capital gains, and other taxes, but even those models that include variation in ability have in general assumed that labour is supplied at a constant rate over the individual's working years (Ordover and Phelps (1975), Sheshinski (1976), Feldstein (1974)). A life-cycle model of individual behaviour that includes both labour supply and consumption decisions is used below. Although a general equilibrium framework is used, for simplicity real capital is ignored; labour is the only factor of production and government debt is the only asset available to savers. Only steady states and only linear tax schedules are considered, and the utilitarian social welfare function is used throughout. First, the conditions under which the life-cycle model reduces to the one-period case are derived, as well as the conditions under which the first-best tax policies for the two are identical. Next it is shown that if all individuals are identical, the optimal policy consists of lump-sum taxes together with an interest rate equal to the rate of pure time preference. The non-optimality of the biological interest rate proposed by Samuelson (1958) in his Exact Consumption-Loan Model is discussed. Finally, an upper bound on the optimal marginal tax rate is derived. This bound depends on the elasticity of total labour supply and on the elasticity of demand for debt.

The Transmission Process and the Relative Effectiveness of Monetary and Fiscal Policy in a Two-Sector Neoclassical Model

In traditional Keynesian income-expenditure modelsl the assets included appear to be four: money (government demand debt and bank demand deposits), long-term government bonds, private debts, and physical capital. Although there are four assets in these models, there are only two yields: the rate of return on money, which is institutionally set at zero, and the rate of interest, which is common to the other three assets and is usually identified with the rate of interest on long-term government bonds. This reflects the underlying assumption of the Keynesian theory that capital, long-term government bonds, and private debts are perfect substitutes for one another in wealthowners' portfolios. As a result of this assumption there is only one yield differential to explain, or, alternatively, only one portfolio choice-that between money and earning assets. This assumption may also be responsible for the failure of Keynesian models to relate explicitly the stock of real capital to the flow of investment spending [38, p. 106] . One line of development subsequent to Keynes' theory of the demand for money has been the disaggregation of assets other than money and the elaboration of liquidity preference theory into a general theory of the relative prices of assets of different types. In recent years this has led to the formulation of a general theory of asset holdings in which the quantity of each asset held is determined by the rates