Rotten Parents and Disciplined Children: A Politico-Economic Theory of Public Expenditure and Debt

Joint with: Zheng Song (Fudan University), Kjetil Storesletten (University of Oslo and CEPR)

This paper proposes a politico-economic theory of debt and government expenditure. Agents have preferences over a private and a government-provided public good, financed through labor taxation. Subsequent generations of voters choose taxation, government expenditure and debt accumulation through repeated elections. Debt raises a conflict of interest between young and old voters as well as between current and future generations.We characterize the Markov Perfect Equilibrium of the dynamic voting game. If taxes do not distort labor supply, the economy progressively depletes its resources through debt accumulation, leaving future generations "enslaved". However, if tax distortions are sufficiently large, the economy converges to a stationary debt level which is bounded away from the endogenous debt limit. The current fiscal policy is disciplined by the concern of young voters for the ability of future government toprovide public goods. The steady-state and dynamics of debt depend on the voters' taste for public consumption. As such taste increases, the economy accumulates less debt. We test the predictions of the theory in the presence of political shocks affecting the taste for public consumption. Government debt should be mean reverting and should increase more under right-wing governments. Data from the US and from a panel of 21 OECD countries confirm these theoretical predictions.

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