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

Abstract

This paper proposes a dynamic politico-economic theory of debt, government finance and expenditure. Agents have preferences over a private and a government-provided public good, financed through labor taxation. Subsequent generations of voters choose taxation, government expenditure and debt accumulation through repeated elections. Debt introduces a conflict of interest between young and old voters: the young want more fiscal discipline. We characterize the Markov Perfect Equilibrium of the dynamic voting game. If taxes do not distort labor supply, the economy progressively depletes its resources through debt accumulation, leaving future generations "enslaved". However, if tax distortions are sufficiently large, the economy converges to a stationary debt level which is bounded away from the endogenous debt limit. The current fiscal policy is disciplined by the concern of young voters for the ability of future government to provide public goods. The steady-state and dynamics of debt depend on the voters' taste for public consumption. The stronger the preference for public consumption, the less debt is accumulates. We extend the analysis to redistributive policies and political shocks. The theory predicts government debt to be mean reverting and debt growth to be larger under right-wing than under left-wing governments. Data from the US and from a panel of 21 OECD countries confirm these theoretical predictions.

Keywords: Fiscal discipline, Fiscal policy, Government debt, Intergenerational conflict, Left- and right-wing governments, Markov equilibrium, Political economy, Public finance, Repeated voting

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