Political Economy of Debt and Growth

53 Pages Posted: 26 Oct 2015 Last revised: 9 Mar 2022

Date Written: October 2015

Abstract

We present a theory of endogenous fiscal policy and growth. Fiscal policy — debt, income tax, spending on local public goods and public investment — is determined through legislative bargaining. Economic growth depends directly on public investment, private investment in human capital and, via learning-by-doing, labor supply. The model predicts that the economy converges to a balanced growth path in which consumption, private investment, public investment, public goods provision, public debt and productivity grow at the same constant rate. The transition to the balanced growth path is characterized by what we call the shrinking government effect: public debt grows faster than GDP, provisions of public goods and infrastructure grow slower than GDP and the tax rate declines. We use the model to study the impact of austerity programs which impose a ceiling on the amount of public debt a country can issue.

Suggested Citation

Battaglini, Marco and Barseghyan, Levon, Political Economy of Debt and Growth (October 2015). NBER Working Paper No. w21660, Available at SSRN: https://ssrn.com/abstract=2679698

Marco Battaglini (Contact Author)

Cornell University ( email )

Ithaca, NY 14853
United States

Levon Barseghyan

Cornell University ( email )

Ithaca, NY 14853
United States

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