The political economy of government debt Advanced Political Economics Fall 2011 Riccardo Puglisi

Main Questions Why do we observe such large differences in public debt policies across countries and within one country across time? Optimal taxation and Ricardian equivalence provide no valid intution

Idea (guess what) We need to link debt policy to political environment Political Environment Debt Policy

Different solutions: Debt issue changes the incentives for future policy makers PERSSON-SVENSON (QJE 1989): different expenditure levels TABELLINI-ALESINA (AER 1990): different expenditure composition Debt redistributes across generations -TABELLINI (JPE 1991) Weak Government do not control the expenditure: common pool problem -VELASCO 1992 Budget institutions matter -ALESINA-PEROTTI (1996)

TABELLINI-ALESINA (AER 1990) “Voting on the budget deficit” Different majorities may differ in their desired composition of government consumption. If the current majority can be replaced by a different majority in the future, the current one can have the incentive to favor budget deficit in order to influence future decisions. Deficit as a state variable which affects future policy decisions PREDICTION: Political instability induces larger deficits

The model: 1.Heterogenous agents decide on two public goods (f, g) 2.Two-period economy 3.The economy is endowed with one unit of output each period 4.Small-open economy borrowing/lending takes place at a given interest rate, equal in the two periods HP: The debt has to be fully repaid at the end of the second period

Budget constraints: with f>0 and g>0, in any period, and Preferences for agent i with concave, strictly increasing and distributed [0,1] Notice that these are intermediate-preferences over (f,g). We can apply Median voter theorem.

Voting behavior 1.At the beginning of each period, voters choose (g,f) 2.No pre-commitment device Bidimensional voting in period 1 Unidimensional voting in period 2

To determine the political equilibrium we use backward induction LAST PERIOD: is the median voter in period 2 The problem is under the constraint

FOC: That defines implicitly: Notice that,

We move back to the first period... The problem here is: Notice that the decision over b has both a direct impact and a strategic one. The higher b today, the lower will be the income at disposal tomorrow.

FOC With respect to that defines such that

With respect to b Marginal Gain of b Marginal Cost of b INTUITION: An increase on debt today, increases your consumption today but decreases it tomorrow. The higher is the distance on preferences between today and tomorrow majority, the higher will be the incentive for today majority to issue debt.

Solution To solve the game, we have to impose some restrictions on the distribution of α CASE I In case we have always the same median voter we can rewrite the FOC in the first period as: Because of the last period FOC and because of the budget constraint:

This situation implies b=0 INTUITION: If median voter today and tomorrow have identical preferences, there is no incentive to debt issue

CASE II with positive probability (A)Consider the case that either In this case, we know that in the second period PROP. 1: (i) If either, then b*>0 (ii) b* is greater the larger is the difference between and the expected value of INTUITION: Again an increase in today’s debt increases utility today but decreases tomorrow spending. However, with positive probability, this reduction will only affect the good the median voter cares little ( no fully internalization of costs)

(B) Consider that and it is distributed according to the c.d.f. H( ) Then, the FOC for the first period becomes: Where and λ is a concavity index on the utility, such that:

HP: The concavity index of u(x), λ(x) is decreasing in x, for any x (0,1) An example of function that satisfies this condition is PROP. 2: Given, then b*>0 if the above assumption is satisfied Idea of the proof (sketchy): At b=0, the FOC is still positive, meaning then, the optimal level of debt must be positive.

DEF (Polarization): The probability distribution H(α) is more polarized relative to α than K(α), if for any continous increasing function f( ), the following condition is true: The idea is that a more polarized distribution assigns more weight to values of that are more further away from PROP. 3: If the hypothesis is satisfied, b* is larger the more polarized is the probability distribution of relative to over the interval (0,1) NOTICE: The opposite of proposition 2 and 3 is true for λ increasing

B A EP 2 u2u2 u1u1 EP 1 The downward sloping line is the budget constraint if b=0 A and B are the point chosen by and at b=0 u 1 and u 2 are the indifference curves of one individual in the two periods EP 1 and EP 2 are the income expansion paths of the two types

Intuition Then, in general, at b=0, there are two opposing effects of a change in b: 1. If b<0 (surplus), less income in the first period and more income in the second. Then, u 1 moves to the left and u 2 to the right; equivalent to buy an insurance 2.If b>0 (deficit), more income in the first and less in the second. u 1 moves to the right and u 2 to the left. Add more consumption today, when the median voter decides the composition of spending, and decrease consumption tomorrow. If the condition on the concavity index is satisfied (2)>(1) DEFICIT

Positive implications 1.The greater the instability, the larger the deficit 2.The greater polarization, the larger the deficit