Analysis of the short- and long-run effects of budgetary policies is one of the most controversial issues in modern macroeconomics. In `representative household' models with intergenerational bequests, public debt has no effect on households' wealth positions, because they take full account of the future taxes that will be levied to finance interest payments. In `overlapping generations' models, however, households do not take full account of the higher taxes that future generations will pay to finance the interest payments, so public debt does affect the wealth of the current generation. Budgetary policies therefore have no effect on private consumption, output or the capital stock in a representative household economy, while in an overlapping generations economy they do.

In traditional models, economic growth is driven by exogenous population growth or labour-augmenting technical progress, and in overlapping generations versions budgetary policies affect steady-state levels of per capita consumption, capital and output, but not growth. In Discussion Paper No. 496, Research Fellows George Alogoskoufis and Frederick van der Ploeg focus on the effects of budgetary policies in both representative household and overlapping generations models of long-run endogenous growth. For a simple overlapping generations model, a steady-state increase in the public debt/output ratio financed by lump-sum taxes reduces long-run growth and increases the share of private consumption in national income. A steady- state, balanced-budget increase in the share of government consumption reduces both long-run growth and the share of private consumption. In contrast, for a representative household economy, the substitution of debt for tax finance has no effect, and a balanced-budget increase in the share of government consumption crowds out private consumption one-for-one, with no effect on growth.

Alogoskoufis and van der Ploeg then assess the dynamic effects of budgetary policies. A temporary tax cut leads to a jump rise in the private consumption/income ratio and an adjustment path with rising ratios of public debt and private consumption to income. Growth jumps downwards and continues falling to a new equilibrium long-run growth rate. Thus a deferral of taxes and the consequent debt accumulation produce both short- and long-run reductions in growth, which may explain the low correlations between real interest rates and both budget deficits and growth often found in empirical studies using overlapping generations exogenous growth models. Once growth is endogenous, real interest rates are determined solely by the user cost of capital and are unaffected by budgetary policies, while the difference between the real interest rate and the growth rate depends not only on preferences but also on budgetary policies, so there is no particular reason for them to be highly correlated. These results suggest that budgetary policies far from being neutral have long- term effects on economic growth that will dwarf their short-run effects on other macroeconomic variables.

On Budgetary Policies and Economic Growth
George Alogoskoufis and Frederick van der Ploeg

Discussion Paper No. 496, December 1990 (IM)