Fiscal Policy in Dynamic Economies

Fiscal Policy in Dynamic
Economies
The role of fiscal policy in short-run macroeconomic stabilisation is, by now,

well known in the academic literature and in policy circles. However, this focus
on the short-run, especially in a democracy, means that much less attention has
been paid to the other consequences of the use of fiscal policy. By studying
the intergenerational-welfare aspects of fiscal policy, this book deals with some
fundamental issues of fiscal policy. Why does public debt tend to rise over time
in democracies? Why is there a tendency for government spending on consump-
tion and on social security to be favoured by politicians? Why do governments
fail to invest in public capital adequately? Should a dollar transferred from the
young be treated as a dollar transferred to the old? By studying the international
aspects of fiscal policy, the book considers some basic questions of fiscal policy
in open economies. Can international differences in fiscal policy drive persistent
trade imbalances and international indebtedness? What criteria should be used
to define a successful foreign-aid programme? Why is foreign aid likely to fail
in a world of global wealth disparity? Can reliance be placed on the interna-
tional coordination of austerity to improve welfare in the long run? Is austerity
accompanied by international transfers superior to austerity unaccompanied by
international transfers?
This book based on the OLG model fills a gap on fiscal-policy issues in the
recent spate of books on overlapping generations.
Kim Heng Tan obtained his Bachelor of Engineering from the University of
Adelaide, a Master of Commerce from the University of New South Wales and
a PhD in Economics from the University of Sydney. He wrote his PhD thesis
“Public Policies in Dynamic Open Economies” under the supervision of eminent
international trade theorist Alan Woodland. He taught economics at the University of
New South Wales and Macquarie University in Australia before joining Nanyang
Technological University (NTU). He has published in internationally refereed
journals. He is now retired from NTU but still teaches Macroeconomics for
the MSc (Applied Economics) programme.
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159 Fiscal Policy in Dynamic Economies

Kim Heng Tan
Fiscal Policy in
Dynamic Economies
Kim Heng Tan

First published 2016
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa
business
© 2016 Kim Heng Tan
The right of Kim Heng Tan to be identified as author of this
work has been asserted by him in accordance with sections 77
and 78 of the Copyright, Designs and Patents Act 1988.
All rights reserved. No part of this book may be reprinted
or reproduced or utilised in any form or by any electronic,
mechanical, or other means, now known or hereafter invented,
including photocopying and recording, or in any information
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or registered trademarks, and are used only for identification and
explanation without intent to infringe.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British
Library
Library of Congress Cataloging-in-Publication Data
Names: Tan, Kim Heng, author.
Title: Fiscal policy in dynamic economies / by Kim Heng Tan.
Description: First Edition. | New York : Routledge, 2016. |
Series: Routledge studies in the modern world economy ;
159 | Includes bibliographical references and index.
Identifiers: LCCN 2016002766 | ISBN 9780415603157
(hardback) | ISBN 9781315542843 (ebook)
Subjects: LCSH: Fiscal policy. | Debts, Public. | Social policy. |
International trade.
Classification: LCC HJ192.5 .T356 2016 | DDC 339.5/2—dc23
LC record available at http://lccn.loc.gov/2016002766
ISBN: 978-0-415-60315-7 (hbk)
ISBN: 978-1-315-54284-3 (ebk)
Typeset in Galliard
by Apex CoVantage, LLC
To
my wife and children
This page intentionally left blank
Contents
Preface x
Acknowledgements xii
1 Introduction 1
2 Modelling a closed economy 8

2.0 Introduction 8
2.1 Assumptions and preliminary equations 9
2.2 The model 29
2.3 Differential systems 30
2.4 Concluding remarks 34
Notes on the literature 34
Appendix 36
A2.1 Properties of the indirect-utility function 36
A2.2 Roy’s identity 36
A2.3 Proof that c1ρ is ambiguous in sign 37
A2.4 Properties of the profit function 37
A2.5 Hotelling’s lemma 38
A2.6 Proof that kr < 0 38
A2.7 Deriving the derivatives of the reduced-form
excess-supply-of-capital function 39
3 Equilibrium analysis 45
3.0 Introduction 45
3.1 Examination of functions for equilibrium analysis 45
3.2 Temporary equilibrium 56
3.3 Steady-state equilibrium 62
viii Contents
4 Public debt 69
4.0 Introduction 69
4.1 Intergenerational incidence of public debt
to finance tax cuts 71
to finance government consumption 84
to finance social security 88
Appendix 101
A4.1 Golden rule in the presence of capital-income taxation 101
5 Government consumption 105

5.0 Introduction 105
5.1 Intergenerational incidence of tax-financed
government consumption 106
5.2 Optimal public-good provision in a dynamic economy 118
Appendix 124
A5.1 MRS between a public good and a private good 124
6 Public investment 126

6.1 Destruction of public infrastructure 127
public capital 129
6.3 Optimal public investment 140
6.4 Intergenerational incidence of debt-financed
public capital 144
7 Social security 152

social security 154
7.2 Optimal tax-financed social security 160
Contents ix
8 Modelling open economies 166
8.1 Preliminaries 166
8.2 A dynamic general-equilibrium model
for open economies 173
8.3 The differential systems of equations for open economies 176
9 The trade imbalance story 180

9.1 Preliminaries 181
9.2 Positive analysis 184
9.3 Normative analysis 191
Appendix 198
A9.1 Proof of Lemma 9.1a 198
A9.2 Proof of Lemma 9.2 199
10 Welfare economics of foreign aid 201

10.1 The model 202
10.2 International transfers in a three-nation world 204
10.3 Foreign aid must flow from rich to poor nations 208
10.4 How should a successful foreign-aid programme
be defined? 210
11 Welfare economics of austerity in open economies 215

11.1 The model 216
11.2 Welfare results 218
12 Conclusion 228
Index 235
Preface
Recently, there has been a spate of books published on the overlapping-generations

(OLG) model, as exemplified by de la Croix and Michel’s (2002) A Theory of
Economic Growth: Dynamics and Policy in Overlapping Generations, Bewley’s
(2007) General Equilibrium, Overlapping Generations Models, and Optimal Growth
Theory, Tvede’s (2010) Overlapping Generations Economies, Farmer and Schelnast’s
(2013) Growth and International Trade: An Introduction to the Overlapping Gen-
erations Approach, and Farmer and Bednar-Friedl’s (2014) Intertemporal Resource
Economics: An Introduction to the Overlapping Generations Approach. As it is not
the intention of these books to deal with policy issues, except for de la Croix
and Michel’s book, this book based on the OLG model is intended to fill a gap
in dealing with fiscal-policy issues.
As I have done research and published in the area of fiscal policy, my original
intention was to write a book integrating the several pieces of journal papers
that I have published and some papers that I have not published. However, as
I wrote, the book took on a life of its own. Although the book builds on the
journal papers that I have published, as I reflected on the issues and pursued
basic, fundamental questions, the end product of the book is now fundamen-
tally very different from what I originally intended it to be. Several results and
findings in the book are published here for the first time and, as far as I am
aware, I believe these results are new. These include why government spending
on consumption and on social security tends to be favoured by politicians in
capitalist democracies (in Chapters 5 and 7 respectively), why public invest-
ment is anathema to politicians (in Chapter 6), why a dollar should not be
treated as a dollar in making transfers from the young to the old away from
the golden rule (in Chapter 7), why foreign aid is likely to fail in a world of
global wealth disparity (in Chapter 10), and why two policy instruments in the
form of internationally coordinated austerity accompanied by foreign aid may
not necessarily work better than a single policy instrument of internationally
coordinated austerity unaccompanied by foreign aid (in Chapter 11). I hope
readers will find these perspectives to be interesting although fiscal policy is
as old as economics itself, and a voluminous literature has been written on it.
In writing this book, I have not followed the convention of writing down
a specific model for each chapter on the question of interest and building up
Preface xi
the model as each chapter progresses to the next. Instead, I have opted to put
upfront in Chapter 2 a single, fully integrated and unified model containing all
the fiscal policy instruments of interest in this book for a closed economy, and
in Chapter 8 a fully integrated and unified model for open economies. Each of
the chapters from Chapter 4 through Chapter 7 and from Chapter 9 through
Chapter 11 contains a special case of the model in Chapter 2 or Chapter 8 to
study the fiscal-policy instrument of interest or to study the fiscal-policy issue
or problem. I have opted for this presentation format as the reader can always
trace the model for each policy instrument or policy issue to the same unified
model for a closed economy or for open economies. Rather than writing down
a different government-budget constraint for the policy instrument of interest
(in order to focus on that policy instrument and ignore other policy instruments
not relevant to the issue at hand), the same government-budget constraint in
Chapter 2 or Chapter 8 is always used. Where this results in a complex solution,
as in the case when capital-income taxation is included, we merely set the tax
policy variable to 0 to obtain a simple solution. I do think that, because this
book adopts a fully dual approach, using this presentation format leads to a
more economical presentation outcome than the alternative of writing down a
separate and different government-budget constraint for the policy instrument
of interest for each chapter.
The audience that I am targeting for this book includes advanced under-
graduate students, postgraduate students, researchers and economists who are
interested in policy issues. The book can be used as a supplementary text for
courses in Macroeconomics, Public Finance, and Economic Modelling.
Acknowledgements
In writing this book, I am indebted to several persons. First and foremost, I

am extremely indebted to Alan Woodland, who was my thesis advisor at the
University of Sydney from 1987 to 1990, for his lessons on economic theory
and modelling and for the experience of those years of writing my thesis under
his tutelage and mentorship. I would also like to thank Daniel Leonard and
Hideo Suzuki, from whom I learnt Mathematical Economics at the University
of New South Wales in the early 1980s. I learnt duality theory from Daniel, and
I’m sure both he and Alan would have approved of my use of the approach in
this book. In addition, I would like to thank Murray Kemp for his comments
over the years on my research papers. Several results in this book build on and
extend my works in those papers. I am also indebted to Professor Lim Chong
Yah, who every so often in our lunch conversations would impress upon me
the need to ask fundamental and basic questions. If I have succeeded in asking
the relevant basic and fundamental questions in this book, it is because I have
heeded his advice. Thanks also to Yong Ling Lam of Routledge for her patience
and support in putting up with my repeated requests for extending the deadline
for submitting the manuscript. I would also like to thank Nanyang Technologi-
cal University for the use of its excellent online library facilities, which have
facilitated greatly my research and writing. Last but most, I would like to thank
my wife, Tin, and my children, Xian and Sheng, for their love and support. To
them, I dedicate this book!
1 Introduction
In modern economies, governments have come to play an ever-increasing role in

the allocation and distribution of society’s resources. Government action through
spending on the provision of public goods confers benefits on the private sec-
tor by improving the wellbeing of consumers. Government spending on public
capital such as public infrastructure confers benefits on the private sector by
enhancing the productivity of producers. By conferring benefits on the private
sector through public consumption and public investment, governments can
reallocate resources by changing the composition of private spending relative
to public spending in final output. Government action through taxation and
borrowing extracts resources from the private sector, while subsidies/transfers
transfer resources to the private sector. By extracting resources from and trans-
ferring resources to the private sector, governments redistribute income within
the private sector that can increase or decrease income inequality. Whether
resources are reallocated or redistributed by government spending, taxation and
borrowing, such policy actions impinge on savings and capital accumulation and,
in turn, affect output, employment, prices and other economic variables. By
affecting output, employment and prices, the policy actions can influence the
stabilisation of the macro-economy. In the terminology of Musgrave (1959),
governments through their policy actions perform the roles of the allocation
and distribution of resources as well as the stabilisation of the macro-economy.
The government actions of spending, taxation and borrowing are, collectively,
termed fiscal policy in this book. By a fiscal policy instrument, we refer to the
individual policy action such as government spending in the form of public
consumption or public investment, taxation in the form of labour-income taxa-
tion or capital-income taxation, transfers in the form of social security to the
old, government borrowing, and so on.
This book is about fiscal policy in dynamic economies. We study the effects
of exogenous increases in the fiscal-policy instrument of interest as well as its
optimal provision. Since the effects of fiscal policy are felt not only intertem-
porally, but also internationally, both dimensions of fiscal policy are considered
with the intergenerational effects being studied in the first part of the book and
the international effects in the second part.
2 Introduction
Following the formulation of a dynamic model for a closed economy in Chap-
ter 2 and a study of equilibrium analysis in Chapter 3, we commence with a
study of public debt in Chapter 4. We study the intergenerational redistribution
of welfare due to public debt in financing tax cuts, government consumption
and social security. In each case, we find that increasing public debt redistrib-
utes welfare from future generations to the present generation simply because
future generations will have to pay for retiring and servicing the debt. Why is
this intergenerational redistribution of welfare of interest? The reason is that it
provides a simple basis to understand why public debt is used so frequently as
a source of finance and why it rises over time in capitalist democracies subject
to the electoral cycle.
In Chapter 5, we study the intergenerational incidence of government con-
sumption as well as the optimal provision of government consumption. It is
usual in the literature in such studies to assume that government spending does
not affect private consumption. We relax this assumption by allowing for the
possibility that government spending may affect the intertemporal allocation
of consumption. In studying the intergenerational incidence of government
consumption, we are interested ultimately in how the time path of welfare of
consumers is affected by government consumption. Government consump-
tion redistributes welfare intergenerationally by affecting the time paths of the
interest rate and wage rate as well as conferring utility directly on consumers.
We show how the intergenerational distribution of welfare due to government
consumption is affected by the degree of substitutability between public and
private consumption.
To gain insight into how the welfare of different generations is affected by
government consumption, we consider optimal public-good provision and revisit
Samuelson’s (1954) condition that optimal provision requires the sum of the
marginal rates of substitution (MRS) between the public good and a private
good to be equal to the marginal rate of transformation (MRT). We show that
Samuelson’s condition, which holds true for an economy without distortions,
has to be modified to include a cost of the distortion arising from the economy
not being at the optimal or golden-rule value of the capital stock. This cost,
which may be interpreted as a dynamic cost in contrast to the static cost of
financing the public good, is affected by the state of the economy relative to
the golden rule as well as by the degree of substitutability between public and
private consumption. What is most interesting in our study of optimal provision
is to show that the marginal social cost of public-good provision for generation 1
is lower than that for all future generations including those in the long run.
The implication of this is that any incoming government due to a change of
political parties in power will not commit to the levels of government spend-
ing according to the long-run policy on optimal public consumption and will
instead opt for optimal government spending as prescribed for generation 1.
The reason for this is that, as the marginal social cost is lower for generation 1, more
government spending can be committed to and more votes can be garnered from
the electorate to stay in power. Consequently, politicians vying for political power
Introduction 3
in capitalist democracies tend to favour government spending on consumption
with the result that public-consumption levels tend to exceed the optimal amount
prescribed for the long run.
We study a number of issues related to public capital in Chapter 6. The first
issue is the basic one of the consequences for the macro-economy when public
infrastructure is unexpectedly destroyed. This issue has become more relevant
in recent years as a result of the increasing frequency of natural disasters. The
second issue is concerned with how public capital affects welfare intergenera-
tionally. Studying the intergenerational incidence of public capital through a
better understanding of how the costs and benefits of public capital are shared
intergenerationally helps policy makers make better decisions in implementing
infrastructure projects. To provide more insight into how welfare is affected by
public capital, we consider optimal public investment and revisit Kaizuka’s (1965)
condition that optimal public-capital provision requires the sum of the marginal
product of public capital to producers to be equal to the marginal cost of public
capital. However, Kaizuka’s condition is concerned with productive efficiency,
whereas the optimal level of public capital we are seeking is concerned with
economic efficiency. A key finding from our study of optimal public investment
is that the marginal benefit in the short run is less than that in the long run as
it takes time to build public capital and to enjoy the productivity gains. This
finding implies that spending on public capital is not a vote-enhancing policy
instrument unlike other forms of government spending. Consequently, some
democracies may fail to invest adequately in public capital.
We study social security in Chapter 7. The incidence of social security is
concerned ultimately with the intergenerational distribution of welfare due to
social security. To gain insight into how welfare is affected by old-age transfers,
we consider the optimal provision of old-age transfers funded by labour-income
taxes, the so-called pay-as-you-go system of social security. In studying the opti-
mal provision of social security, we find that the marginal social cost facing the
first generation is less than that for all future generations. This finding implies
that, like government spending on consumption, spending on social security is
favoured by politicians vying for political office and tends to be larger than the
optimal amount prescribed for the long run. We also find that, in the optimal
provision of social security, the marginal utility of a dollar transferred from the
young is not equal to that of a dollar transferred to the old away from the
golden rule. This finding, arising from the diminishing marginal utility of income,
emerges from our analysis based on efficiency considerations, and is not imposed
as a value judgement. The significance of this finding is that, where transfers
have to be optimally effected away from the golden rule, not recognising that
‘a dollar is not a dollar’ can lead to sub-optimal outcomes for public policy.
When fiscal policy is considered in open economies, fiscal policy can encompass
more policy instruments such as export and import taxes, taxes on foreign-
investment income and international transfers. As these policy instruments are
usually studied in international trade, they will be ignored in this book with
the exception of international transfers. We incorporate international transfers
4 Introduction
into the government budget and treat international transfers as a fiscal-policy
instrument for the reason that we will be studying austerity in open economies,
and that a pertinent question to ask is whether achieving welfare improvement
in the international coordination of austerity in open economies depends on
international transfers.
Following Chapter 8’s model formulation for open economies, we commence
our study of the international aspects of fiscal policy in Chapter 9 by examining
the positive and normative implications of international differences in fiscal policy.
We revisit Gale’s (1971, 1974) trade-imbalance story that persistent imbalances
in trade and current accounts are driven by international differences in technol-
ogy or taste by asking: given that nations typically differ in fiscal policy in terms
of differences in the levels of government spending, taxation and borrowing,
can international differences in fiscal policy lead to persistent imbalances in
international indebtedness and trade? If so, this would be paradoxical for two
reasons. First, it seems infeasible in a budgetary sense that any nation could be
in perpetual debt to another nation. Second, it seems inefficient that any nation
would be a perpetual net exporter of goods when the net exports could have
been consumed. A related but normative issue is how international differences
in fiscal policy affect the intergenerational distribution of welfare for nations
under international trade relative to autarky.
As a prelude to studying austerity in open economies, we study international
transfers in Chapter 10. We ask some basic questions on foreign aid. What
criteria should be used to define a successful aid programme? What should
policy makers look for in designing a successful foreign-aid programme? Seeking
solutions to these questions is important in determining whether and when to
extend foreign aid. Unfortunately, in seeking solutions to these questions, we
arrive at a dismal conclusion: foreign aid is likely to fail in a world of global
wealth disparity.
Finally, we consider the issue of austerity in open economies in Chapter 11.
The effects of austerity in open economies are not the same as those in a closed
economy. Whereas a closed economy can improve its welfare in the long run by
cutting public debt (Diamond, 1965), welfare improvement is not guaranteed if
an open economy undergoes austerity unilaterally (Persson, 1985). If a nation
cannot rely on cutting public debt unilaterally to attain long-run welfare improve-
ment, can reliance be placed on the international coordination of austerity (at
least among a group of economies) to achieve Pareto improvement in the long
run? This issue is of relevance to economies, such as the Eurozone countries,
that have been engaged in austerity in the wake of the Eurozone debt crisis. In
a fiscal union, such as the United States, a transfer to the poorer member states
would have helped these states under austerity situations. For countries that are
not a fiscal union, like the Eurozone, we take up the issue of whether austerity
accompanied by international transfers from the richer nations to the peripheral
nations is superior to austerity unaccompanied by international transfers.
The issues addressed in this book are studied within a dynamic general-
equilibrium (DGE) framework using Diamond’s (1965) version of the
Introduction 5
overlapping-generations (OLG) model due to Samuelson (1958). In this model,
consumers form overlapping generations and live for two periods. They work
and save in the first period, and retire and consume their savings in the sec-
ond period. Producers produce a single good using labour and private capital
rented from consumers and public capital supplied by the government. The
government taxes labour and capital income and borrow to spend on a public
good and public capital and to provide pensions to the old. Extended to the
open-economy context, governments are also engaged in international transfers
under perfect capital mobility and international trade.
We employ the OLG model rather than the Ramsey (1928) model that is
currently in vogue in Macroeconomics for the simple reason that a large part of
this book is devoted to studying the intergenerational redistribution of welfare,
for which the Ramsey model is ill-suited to the task as it employs a representative
consumer that lives forever. On the other hand, the OLG model captures the
finite life-span of consumers and is the appropriate medium to use for analysing
the intergenerational distribution of welfare.
The OLG model that is employed in this book possesses two distinctive
features. First, it is fairly general and unified, containing a set of varied fiscal-
policy instruments that includes government consumption, public investment,
public debt, taxation of labour income and capital income, and social security to
the old. Extended to the open-economy context, the set of fiscal-policy instru-
ments includes international transfers. Second, the model in this book adopts
consistently a dual approach throughout and contrasts with the semi-duality
approach of other dynamic models in much of the literature. In the duality
approach as opposed to the primal approach, functions are expressed in terms
of prices rather than in terms of quantities. The duality approach yields results
in a simple and intuitive manner.
The formulation of the OLG model and its solution in differential com-
parative-statics form are taken up in Chapter 2 for a closed economy and
in Chapter 8 for open economies. The solution of the model in differential
comparative-statics form will be required for the short-run and long-run analyses
of the issues to be addressed in this book. Equilibrium analysis of the model
solution for a closed economy is examined in Chapter 3. Equilibrium analysis
is concerned with the investigation of the conditions under which choices of
economic agents are made compatible in the sense that supply equals demand
in every market. The usual questions on the existence, uniqueness and stability
of equilibrium will be investigated. Equilibrium analysis is important for the
following reasons. The study of the existence of equilibrium is important in
that, if no equilibrium exists, the model would be of no value to the analysis
of the issues to be addressed. The study of the uniqueness of equilibrium is
to make the model more complete. If several equilibria exist in the model,
then the model would be incomplete in the sense that it does not indicate
which of the equilibria would be realised. Finally, the study of the stability of
equilibrium is useful in eliminating ambiguities in the signs of certain partial
derivatives for comparative-statics analysis.
6 Introduction
The reader will find in this book several results that are new (as far as I am
aware). These include why government spending on consumption and on social
security tends to be favoured by politicians in capitalist democracies, why some
democracies may not invest in public capital adequately, why a dollar is not a
dollar in making transfers from the young to the old away from the golden rule,
why foreign aid is likely to fail in a world of global wealth inequality, and why
two policy instruments are not necessarily superior to a single policy instrument
in the context of austerity and international transfers. I hope these are sufficient
reasons to whet the reader’s appetite for more on fiscal policy in this book.
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Fiscal Policy in Dynamic

The role of fiscal policy in short-run macroeconomic stabilisation is, by now,

151 Cultural Differences and Economic Globalization

152 Human Development and Capacity Building

153 The Economics of Terrorism

154 Culture, Institution, and Development in China

155 The Economics of Waste Management in East Asia

156 Global Economic Crisis and Local Economic Development

157 Liberalism and Chinese Economic Development

158 The Financialization of Housing

159 Fiscal Policy in Dynamic Economies

Kim Heng Tan

2 Modelling a closed economy 8

5 Government consumption 105

6 Public investment 126

7 Social security 152

9 The trade imbalance story 180

10 Welfare economics of foreign aid 201

11 Welfare economics of austerity in open economies 215

Recently, there has been a spate of books published on the overlapping-generations

In writing this book, I am indebted to several persons. First and foremost, I

In modern economies, governments have come to play an ever-increasing role in

Modelling open economies

The trade imbalance story

Welfare economics of austerity in open economies

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2 Modelling a closed economy 8

5 Government consumption 105

6 Public investment 126

7 Social security 152

9 The trade imbalance story 180

10 Welfare economics of foreign aid 201

11 Welfare economics of austerity in open economies 215