Rotten Parents and Disciplined Children: A Politico-Economic Theory of Public Expenditure and Debt

Abstract

This paper proposes a dynamic politico-economic theory of fiscal policy in a world comprising a set of small open economies, whose driving force is the intergenerational conflict over debt, taxes, and public goods. Subsequent generations of voters choose fiscal policy through repeated elections. The presence of young voters induces fiscal discipline, i.e., low taxes and low debt accumulation. The paper characterizes the Markov-perfect equilibrium of the voting game in each economy, as well as the stationary equilibrium debt distribution and interest rate of the world economy. The equilibrium can reproduce some salient features of fiscal policy in modern economies.

Keywords: Fiscal discipline, Fiscal policy, General equilibrium, Government debt, High debt in Greece and Italy, Intergenerational conflict, Markov equilibrium, Political economy, Public goods, Repeated voting

JEL Classification: D72, E62, H41, H62, H63