Economics 202A

Lecture Outline #4 (version 1.3)

Maurice Obstfeld
Government Debt and Taxes
As a result of the events of September 2008, government actions to un-
derwrite the U.S. nancial system, coupled with a massive recession and a
huge scal stimulus plan, are sharply increasing the U.S. federal debt. Leav-
ing aside the fascinating questions raised by the nancial crisis itself, how
do macroeconomists think about government debt and its eects? Should
government debt matter at all after all, leaving aside the possibility of bor-
rowing from foreigners, we owe any public debt to ourselves! Because one
logical possibility is that government debt somehow aects capital accumu-
lation and growth, it is natural to consider the question in the context of our
growth models.
The leading breakthrough on the subject is Peter A. Diamonds (Ameri-
can Economic Review 1965) adaptation of Paul A. Samuelsons overlapping
generations model to incorporate capital, growth, and public debt. (Inci-
dentally, this paper was written when Diamond was on the faculty here in
Berkeley.) We shall study the Diamond model soon, but before doing so we
take a look at the debt question within the Ramsey-Cass-Koopmans (RCK)
dynastic family setup. There the answers are less interesting (and perhaps
less intuitive), yet they provide an essential benchmark case for understand-
ing the Diamond models very dierent predictions.
Within the RCK framework we now wish to distinguish between the pri-
vate sector and the government, two sectors that add up to be the total
economy, of course. As we are now therefore dropping the idea that a gov-
ernment planner makes allocation decisions, we need to observe (following
basic welfare economics) that the RCK allocation can be decentralized if pri-
vate agents face the time path of real interest rates corresponding to that
optimal allocation,
:
t
= ,
0
(/
t
)
and earn real wages per unit labor given by the marginal product of labor,
n
t
= ,(/
t
) ,
0
(/
t
)/
t
.
1
[Following Diamond 1965, I assume that the depreciation rate o of capital
is 0; otherwise the real interest rate would be : = ,
0
(/) o.] A key step in
showing this is to contemplate the government and private sectors budget
constraints separately.
With respect to the private sector, household assets at the start of period
t are the sum of capital 1
t
and debt issued by the government, 1
t
. If we
redene these stocks in per capita terms as /
t
and d
t
, and also assume that
the household pays per capita lump-sum taxes t
t
to the government each
period, then we may write the private asset-accumulation equation in terms
of real per capital wealth c / + d as
c
t+1
=
1
1 + :
[(1 + :
t
)c
t
+ n
t
t
t
c
t
] .
Above, :
t
is the interest paid during period t on assets accumulated over
t 1. It is now easy to see that if consumers invest at the real interest rate
:
t+1
between dates t and t +1, then the relevant Euler equation of optimality
would be
n
0
(c
t
) = ,(1 + :
t+1
)n
0
(c
t+1
). (1)
At the same time the governments debt evolves according to the equation
d
t+1
=
1
1 + :
[(1 + :
t
)d
t
t
t
+ q
t
] .
where q is per capita consumption of goods by the government. Since debt
represents negative assets, simply subtract the second of these from the rst
to get
/
t+1
=
1
1 + :
[(1 + :
t
)/
t
+ n
t
c
t
q
t
]
=
1
1 + :
[,(/
t
) + /
t
c
t
q
t
] .
the aggregate relationship from the RCK model (where q 0).
The private and public asset-stock ow relationships above imply innite-
horizon intertemporal budget constraints for the two sectors. For the private
2
sector, for example, we may write (for t = 0),
c
0
=
c
0
(n
0
t
0
)
1 + :
0
+
1 + :
1 + :
0
c
1
=
c
0
(n
0
t
0
)
1 + :
0
+
_
1 + :
1 + :
0
_
[c
1
(n
1
t
1
)]
1 + :
1
+
_
1 + :
1 + :
0
__
1 + :
1 + :
1
_
c
2
=
1
1 + :
0
_
1

t=0
_
t

s=1
_
1 + :
1 + :
s
_
[c
t
(n
t
t
t
)]
_
+ (1 + :) lim
t!1
t

s=1
_
1 + :
1 + :
s
_
c
t+1
_
.
Consider the reasonableness of imposing on households the condition that
lim
t!1
t

s=1
_
1 + :
1 + :
s
_
c
t+1
0.
In the Ramsey economy we can never have a negative capital stock. But
in the decentralized economy, where households borrow subject to a real
interest rate, we can imagine someone borrowing to consume and then al-
ways borrowing more to repay the previous loans, thereby never repaying at
all. The preceding inequality constraint rules out such a Ponzi scheme and
thus is called the no-Ponzi-game constraint.
1
Imposing it, we obtain the
intertemporal constraint
(1 + :
0
)c
0

1

t=0
_
t

s=1
_
1 + :
1 + :
s
_
[c
t
(n
t
t
t
)]
_
. (2)
This restrictions says that household initial assets (along with their payout)
must cover any discounted excess of consumption over after-tax wage income.
[Can you see, using (1), why the transversality condition will normally ensure
that in equilibrium, this condition holds as an equality?]
The government faces an analogous constraint: the excess of its tax re-
ceipts net of public spending, discounted to the present, must cover at least
1
If we do not impose such a constraint, then anyone can consume innite resources and
there would be excess demand for output.
3
its initial debt to the private sector. Because government assets are equal to
d, we may write the public-sector constraint as
(1 + :
0
)d
0

1

t=0
_
t

s=1
_
1 + :
1 + :
s
_
(q
t
t
t
)
_
. (3)
[In words, this implies (just multiply the last inequality through by 1) that
the discounted present value of primary government surpluses t q must be
at least as big as the governments total initial debt obligations (1 + :
0
)d
0
.]
Putting the last two inequality constraints together leads to
(1 + :
0
)/
0

1

t=0
_
t

s=1
_
1 + :
1 + :
s
_
(c
t
+ q
t
n
t
)
_
(4)
for the economy as a whole.
2
The proposition I now wish to explore is the neutrality of public debt in
this economy with lump-sum taxes and a single representative family. The
proposition is known as the Ricardian equivalence of debt and future taxes.
Suppose the government increases its own initial debt by showering a gift
d of government bonds on people at the start of period 0. (Think of the
recent U.S. scal stimulus package.) To nance the payments on this debt,
the government raises taxes intertemporally (perhaps far in the future) by
the amount
d =
1

t=0
_
t

s=1
_
1 + :
1 + :
s
_
t
t
_
[recall that t denotes per capita taxes in (3)]. Notice that this experiment
changes the left-hand and right-hand sides of the household constraint (2) by
equal amounts: there is no change in intertemporal household consumption
possibilities. Accordingly, private consumption behavior also is unchanged.
In other words, the gift of government debt does not represent net wealth
2
In the RCK model with government consumption, we would have
k
t+1
=
1
1 + n
[k
t
+ f(k
t
) c
t
g
t
]
=
1
1 + n
f[1 + f
0
(k
t
)] k
t
+ f(k
t
) f
0
(k
t
)k
t
c
t
g
t
g :
Because 1 + f
0
(k
t
) = 1 + r
t
and f(k
t
) f
0
(k
t
)k
t
= w
t
for the market economy, the result
is constraint (4).
4
for households, because it arrives with the certainty of osetting future tax
payments to the government. (Of course, the private sector is likely to raise
its saving so as to build a fund that can be used to pay the anticipated future
taxes. Private saving is dened as total household income, including interest
earned on government bonds, less consumption.)
That is the prediction of models featuring Ricardian equivalence. Here
indeed, public debt does not matter because the same people who own the
debt pay the taxes indeed, we owe it to ourselves. Diamonds overlapping
generations model is not in this category.
The Diamond Overlapping-Generations Model: Basic Setup
The basic structure assumes that every individual lives for two periods,
but that generations are born in a staggered fashion.
Thus, on a generic date t, a new cohort of agents is born, who live during
period t (when they are young) and period t+1 (when they are old). However,
the next generation is born already on date t + 1, so that the young born
on date t + 1 and the date-(t + 1) old, who were born on date t, coexist (or
overlap) during period t + 1.
Only the young are able to work. Thus, if you are born in t, you work
during t and enjoy retirement during t + 1. Because you wish to consume
on both dates, however, you will attempt to save during your youth. People
cannot leave bequests to members of future generations (and have no motive
to do so), nor are they born with any inherited wealth or with any endow-
ment other than the labor power they have to sell. Otherwise, Ricardian
equivalence could return, as in Robert J. Barros famous 1974 Journal of
Political Economy paper.
The constant-returns production function is 1
t
= 1 (1
t
. `
t
), where `
t
is
the number of young workers on date t. (They supply their labor inelasti-
cally.) The labor force grows according to
`
t+1
= (1 + :)`
t
.
A young worker will put his/her savings into capital, reap the marginal prod-
uct of capital when old, and then also sell the capital to the contemporaneous
young. Capital income and capital sales nance consumption in old age. (As
noted above, capital does not depreciate.)
As usual / 1,`. The young worker of date t receives a wage of
n
t
= ,(/
t
) ,
0
(/
t
)/
t
.
5
while the date-t old receive a per capita income from their investment equal
to
,
0
(/
t
)
1
t
`
t1
= (1 + :),
0
(/
t
)/
t
.
A young worker on date t pays taxes t
y
t
to the government, while an old
worker pays taxes t
o
t
. (It could be that t
o
< 0, for example, if the young
pay social security taxes of t
y
t
and then receive t
o
t+1
in pension payments
in their old age. We will come back to social security later.) Suppose that a
worker born on date t maximizes
l
t
= n(c
y
t
) + ,n
_
c
o
t+1
_
subject to the intertemporal constraint
c
y
t
+
c
o
t+1
1 + :
t+1
= n
t
t
y
t

t
o
t+1
1 + :
t+1
. (5)
Then optimal consumption is determined by combining the budget constraint
with the Euler equation
n
0
(c
y
t
) = , (1 + :
t+1
) n
0
_
c
o
t+1
_
.
Let
:
y
t
= n
t
t
y
t
c
y
t
(6)
denote per capita saving by the young of date t. In old age they will have a
per capita saving rate of
:
o
t+1
= :
t+1
:
y
t
t
o
t+1
c
o
t+1
(7)
(because saving is income minus consumption). From the budget constraint
and (6), however,
c
o
t
= (1 + :
t
) (n
t1
t
y
t1
c
y
t1
) t
o
t
= (1 + :
t
) :
y
t1
t
o
t
.
so by (7), rewritten to apply to period t,
:
o
t
= :
t
:
y
t1
t
o
t
c
o
t
= :
t
:
y
t1
(1 + :
t
) :
y
t1
= :
y
t1
:
what you save when young you simply consume (dissave) while old. As a re-
sult, the capital stock on any date equals the amount saved by the previously
young:
1
t
= `
t1
:
y
t1
,/
t
=
:
y
t1
1 + :
.
6
Those who are old on date t eat this capital completely during t, leaving the
contemporaneous young to put aside the next periods capital stock 1
t+1
through their own savings.
Without losing too much generality, lets compute the equilibrium explic-
itly for a specic example. Assume that n(c) = ln(c) and let 1(1. `) =
1

`
1
. Then the Euler equation can be written as
c
o
t+1
= , (1 + :
t+1
) c
y
t
.
which, together with (5), leads to the solutions
c
y
t
=
1
1 + ,
_
n
t
t
y
t

t
o
t+1
1 + :
t+1
_
.
c
o
t+1
=
, (1 + :
t+1
)
1 + ,
_
n
t
t
y
t

t
o
t+1
1 + :
t+1
_
.
Accordingly,
:
y
t
= n
t
t
y
t
c
y
t
=
,
1 + ,
(n
t
t
y
t
) +
1
1 + ,
t
o
t+1
(1 + :
t+1
)
. (8)
We now can represent the equilibrium as a dierence equation in /.
Because /
t+1
= :
y
t
,(1 + :). n
t
= ,(/
t
) /
t
,
0
(/
t
) = (1 c)/

t
. and
:
t+1
= ,
0
(/
t+1
) = c/
1
t+1
. the last equation can be written as:
/
t+1

1
(1 + :) (1 + ,)
t
o
t+1
_
1 + c/
1
t+1
_ =
,
(1 + :) (1 + ,)
[(1 c)/

t
t
y
t
] .
(9)
The Diamond Model: No Fiscal Policy
Equation (9) is a very general depiction of the economys dynamics (which
is why it looks so complex) and I will show how to analyze it in some scally
relevant cases later. To make some initial points, however, it is useful to take
the special case in which scal policy is absent, so that t
y
= t
o
= 0 on all
dates. In that case, eq. (9) can be written in the much simpler form
/
t+1
=
,(1 c)
(1 + :)(1 + ,)
/

t
1(/
t
).
7
A simple diagram (next page) allows us to analyze this dierence equation.
We use it as follows. Starting at any /
0
on the r-axis, the curved locus 1(/)
indicates the value of /
1
. Project that value horizontally to the 45

line, then
down vertically to nd the location of /
1
on the r-axis. Then repeat the
process using /
1
as the new starting value, from which /
2
is derived.
The picture makes obvious that the economy will converge in a stable,
monotonic fashion to a steady state capital/labor ratio

/ given by

/ =
_
(1 c),
(1 + :)(1 + ,)
_ 1
1
(10)
Steady state capital per worker will be higher if , is closer to 1 (people
are more patient) and if : is lower. The steady state is a balanced growth
path with constant capital per worker. In the steady state, a young worker
consumes
c
y
=
1
1 + ,
n =
1 c
1 + ,

.
while an old retiree consumes
c
o
= (1 + :)(

/ + c

).
With labor-augmenting technical change at rate q, there would be a balanced
growth path with consumptions per capita and capital growing at rate q.
Let us now consider the question of the Golden Rule in this economy;
the situation is dierent from that in the RCK economy, where we saw that
,
0
_

/
_
: always. A central planner might like to maximize total steady-
state lifetime utility of a typical individual

l = n( c
y
) + ,n( c
o
)
subject to the constraint that

/ is constant over time
,(

/) = :

/ + c
y
+
c
o
1 + :
.
If you form the Lagrangian for this problem, you will see that the rst-order
conditions for consumption boil down to
n
0
( c
y
) = ,(1 + :)n
0
( c
o
) .
8
k
t+1
45
o
B(k)
k
t
kk
k
0
k
1
k
1
k
1
k
2
k
2
Diamond Model with no Taxation
But compare this to the individuals Euler equation, eq. (1): the preceding
condition will hold in the steady state that is, the utility of a typical
generation will be maximized only if

/ = /

. where ,
0
(/

) = :

= :. Thus,
the Golden Rule prescription is unchanged from its usual form. However,
unlike in the RCK model, it is perfectly possible that

/ /

in Diamonds
model.
Why? The Golden Rule capital-stock in our specic (log, Cobb-Douglas)
example is
_
c
:
_ 1
1
= /

.
Using (10), you can see that the Golden Rule will be violated if
_
(1 c),
(1 + :)(1 + ,)
_ 1
1

_
c
:
_ 1
1
.
that is, if
_
:
1 + :
__
,
1 + ,
__
1 c
c
_
1.
That this inequality holds is certainly possible (if not highly plausible).
If ,
0
_

/
_
< :, we are in a dynamically inecient situation in which every-
one in the economy could enjoy higher consumption on all dates if some
capital were permanently consumed. In this model, however, the decen-
tralized market is not capable of accomplishing this this. An all-powerful
economic planner could transfer income from young to old however needed
to maximize the utility of a typical generation, as in the last optimization
problem. But in the market economy, the old can consume only if they save
when young.
Lets look at the problem more closely. Normally that is, in models
where resource allocation is ecient agents trade in order to eliminate
unexploited opportunities for mutual gain. Consider a dynamically inecient
steady-state equilibrium of the Diamond model with ,
0
_

/
_
< :, however.
Start at time 0, and imagine that members of the young generation of period
t = 0 could strike the following deal with the young of t = 1. 2. 3. etc. (who,
of course, have not yet been born): we will each pay an amount t,(1 + :)
to the old of period t = 0 if, in turn, every future young generation member
promises likewise to pay t,(1 + :) to its contemporaneous old folks. Let us
9
further set t so that saving by the young results in a capital-labor ratio of
/

. Since / = :
y
,(1 + :). we need t to satisfy the equation
/

=
1
1 + :
_
, [, (/

) :/

]
1 + ,

t
(1 + :)
_
.
[Recall (8), and substitute in n = , (/

) :/

. t
y
= t,(1 + :), t
o
= t,
and : = :.] In this equilibrium, a person pays to the old t,(1 + :) when
young, but receives t when old (because there are 1 + : more young people
next period); and because the interest rate is also equal to :, an individuals
budget constraint in this steady state is:
c
y
+
c
o
1 + :
= ,(/

) :/

.
Observe that if agents can carry out these agreements, they fully replicate the
(optimal) Golden Rule solution to the planning problem. The only obstacle
to this clever scheme is that a generation cannot, in reality, contract with
generations yet to be born! And so the private marketplace cannot bring
about an exit from dynamic ineciency.
The Role of Fiscal Policy
Unless we introduce some sort of redistributive scal policy, there is no
avenue for government to transfer resources to the old so that they will
save less. Fiscal policy is a way for the government to mimic the voluntary
transfers described above, and it works when the (innitely-lived) government
can make binding commitments on behalf of generations that are yet to be
born.
3
In that scenario, the government simply taxes the young to subsidize
the old: the young pay t,(1 +:) per capita and the old receive t per capita;
the budget is balanced date by date.
The alert reader will ask the following: suppose we are at a

/ that is below
the Golden Rule level /

. By doing the above scheme in reverse, could we

not move to the steady-state-consumption-maximizing Golden Rule? The
answer is yes, but we would have to tax the initial old to pay the initial
young, so the rst generation of old is worse o even though everyone else
3
But can it? A young generation, outnumbering the old, could simply vote to change
the law and thereby default on their payment to the old. In reality, the sustainability of
an eciency-enhancing scal scheme is therefore a question in political economy. Such
matters are fascinating but beyond the scope of this course.
10
may be better o. (They die after being taxed; so, unlike the young, they do
not recoup their losses as a subsidy later on.) Thus, it is only in the case of
dynamic ineciency that there is scope for a Pareto improvement. In moving
from

/ /

to /

, we were able to make everyone better o (including the

t = 0 old, who received a positive payment).
Public Debt
We stick with the log utility/Cobb-Douglas example. Let the government
maintain a public debt of 1
t
,`
t
= d forever. To do so, assume that the young
only are taxed; t
o
0. If t
y
t
is the per capita (lump-sum) tax that is levied
on a young person, the ow government budget constraint is
1
t+1
= (1 + :
t
)1
t
`
t
t
y
t
.
In order that the public debt per young person remain constant over time,
we need
d =
1
t+1
`
t+1
=
(1 + :
t
)1
t
`
t
t
y
t
`
t+1
=
1 + :
t
1 + :
d
t
y
t
1 + :
) t
y
t
= (:
t
:) d
= [,
0
(/
t
) :] d.
Imagine that the government endows the initial old with d and levies the
indicated tax on the young at the same time. In the rst period the old have
very high consumption, and the young must buy the debt from them. In
the second period the capital stock still reects the impact of the very high
period 1 consumption of the old. By period 3 the economy has settled down
to the relation implied by eq. (9), modied for the fact that the young must
now purchase the debt as part of their savings in addition to any capital they
accumulate:
d + /
t+1
=
,
(1 + :) (1 + ,)
_
(1 c)/

t

_
c/
1
t
:

d
_
.
The eect is to shift downward the curved 1(/) locus in the Diamond dia-
gram, as shown on the next page. There is a unique stable steady state, with
a lower long-run capital stock per worker. (There is also a second steady
state with a nonzero capital level, but it is unstable.)
11
k
t+1
45
o
k
t
Diamond Model with Public Debt
What are the welfare eects? (Please verify what follows!) If initially the
economy is dynamically ecient (

/ /

), then the initial old who receive

the gift of debt are better o, and all subsequent generations are worse o.
There is a capital crowding out eect because people put their savings into
unproductive public debt rather than productive capital; and because we
are to the left of the Golden Rule, more capital is better. In this sense,
accumulating public debt today impoverishes future generations, even though
society owes the debt to itself. (Perhaps surprisingly, matters are even worse
in the closed economy than if the debt is owed to foreigners! See Diamond
1965.)
If, however, the economy initially is dynamically inecient (

/ /

),
public debt paradoxically makes all generations better o by crowding out
excessive capital. A public debt acts like a scheme of transfers from young to
old the young pay taxes to the government, which transfers them to the old
in the form of interest payments on government debt. So it works just like the
hypothetical Pareto-improving scheme we discussed above with the debt
providing a way for generations not alive at the same time eectively to trade
with each other. In this setting, the promise that the government will always
honor its debt works like a compact between present and unborn generations.
That compact can be broken, however, if the government decides to default
on its debt.
Social Security
Unfunded social security the prevailing arrangement nowadays in the
United States and most other countries is exactly like public debt in its
eects. Government taxes the young (social security taxes) and makes trans-
fers to the old (social security payments). The scheme reduces the capital
stock. Capital-stock reduction is benecial, of course, only in the dynamically
inecient case.
In the case of fully funded social security the government taxes the young
but invests the proceeds in capital /, using the return on the capital to pay
the old. Because in this scheme the savings of the young are not diverted
into government paper, crowding out can be avoided.
The Possibility of Asset Bubbles under Dynamic Ineciency
Suppose the government issues an asset that pays no dividend. Think of
it as a piece of paper carrying George W. Bushs portrait. In a dynamically
ecient economy the paper will have no value. In the dynamically inecient
12
economy, however, there can be a Bush bubble: the paper will have value
(and its value will even rise through time) if every generation believes that
future generations will value it.
Let the number of Bush portraits be 1 and the price of each one (in terms
of output), j. Savers will be willing to hold the paper provided its price rises
at the (gross) rate of interest:
j
t+1
j
t
= 1 + :.
This means, also, that the supply of the asset, j
t+1
1,j
t
1. rises at rate
1 + :. The supply of savings in the economy, however, grows at the gross
rate 1 + : 1 + :. So as long as j
0
1 does not exceed the initial savings of
the young, the young will always be able to buy the available supply of Bush
portraits, and will be willing to do so because they yield the same return as
does capital.
Furthermore, the Bush asset will have the benecial eect of crowding
out some excess capital. In eect, we are looking at an equilibrium in which
future generations promise to purchase the paper at a specic price, and
the resulting expectation takes the place of a hypothetical (but infeasible)
contract among unborn generations.
This bubble is not sustainable if : : because in that case, the value of
the articial asset eventually comes to exceed the savings of the young, at
which point a price collapse is inevitable. As a result of this terminal infea-
sibility, the only possible equilibrium is j
0
= 0 in the dynamically ecient
case.
For more details, see the paper by Tirole in Econometrica (November
1986).
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