Skip to main content

About this book

Today, the most pressing challenges for public economics are of macroeconomic nature: pensions, debt, income distribution, and fiscal sustainability. All these problems are compounded by the phenomenon of demographic transition and aging. This graduate textbook addresses these issues with the help of state-of-the-art macroeconomic tools that are based on a sound microfoundation and rooted in empirical evidence. Different from the standard partial-equilibrium analysis in traditional textbooks on public economics, the concept of general equilibrium helps to account for compensating or amplifying side-effects of economic policy.

GAUSS and MATLAB computer code as well as teaching material (slides) are available as downloads from the author's homepage.

Table of Contents


1. Introduction

Public economics studies the problems of government expenditures and revenues. Almost all major graduate textbooks on this issue focus on an exclusively microeconomic presentation. Modern problems in public economics, however, are inherently macroeconomic in nature. Just consider what are arguably the most important problems facing modern industrialized countries: demographics, debt, and pensions. As a consequence, many textbooks on public economics are awfully shy about these pressing issues that were aggravated by the recent financial crisis.
Burkhard Heer

Useful Models


2. Ramsey Model

This chapter presents the Ramsey model. It is the benchmark model for most dynamic macroeconomic models that study growth and business cycle phenomena. We first study the deterministic Ramsey model in which the total factor productivity is certain. We contrast the effects of a once-and-for-all change with those of a temporary change in productivity on investment, output, and labor supply. In addition, we distinguish the effects of this change when it is known in advance or only observed at the beginning of the period, t, when the shock occurs. Finally, we also introduce uncertainty with respect to the technology level and discuss the real business cycle (RBC) model.
Burkhard Heer

3. The Overlapping Generations Model

This chapter investigate the standard overlapping generations (OLG) model with two periods. It serves as one of the main tools to study problems in modern public finance such as pensions, unemployment insurance, and debt. The standard OLG model will be shown to be possibly Pareto-inefficient. In addition, we discuss the problem of stability and note that it is less relevant for the large-scale OLG models that we consider in later chapters than for simple two-period models. With the help of an example, we show that the transition in the OLG model might take place over very long time horizons exceeding several decades. In addition, important extensions of the standard two-period OLG model such as bequests and growth are introduced.
Burkhard Heer

Fiscal Policy


4. Government Consumption

Empirically, government expenditures represent a large share of total demand and significantly affect output, employment, and welfare. In the introductory Sect. 4.2 of this chapter, we document some selected empirical facts of government consumption. In particular, we find that government consumption is procyclical, and after an unexpected increase in consumption, output, employment, and (to a smaller extent) private consumption all increase.
Burkhard Heer

5. Income Taxation

After a brief survey of the empirical findings on income taxation in the US and German economies in Sect. 5.2, you learn about the substantial welfare costs that are associated with the taxation of labor income. In Sect. 5.3, these costs are computed in both partial and general equilibrium. As one result, the deadweight loss of labor income taxation in Germany is found to be twice as high as the one in the US. In Sect. 5.4, the seminal result from optimal taxation that capital income should not be taxed in the long run is derived and discussed critically. Section 5.5 estimates the US Laffer curve and shows that the US government, in contrast to many European governments, can still raise its revenues from labor and capital income taxation by approximately 10% of GDP. In Sect. 5.6, the quantitative effects of higher taxes on economic growth are derived in a Dynamic General Equilibrium (DGE) model and are shown to be substantially higher than those typically found in growth regressions. Finally, we demonstrate that stochastic taxes improve the time series properties of the real business cycle (RBC) model with respect to the volatility of aggregate demand components and the dynamics of labor and wages in Sect. 5.7.
Burkhard Heer

Social Security, Demographics, and Debt


6. Pensions

In this chapter, we first review empirical facts of public pension systems in OECD countries. Subsequently, we introduce a public pension system in the standard two-period overlapping generations (OLG) model of Chap. 2. We consider two different social security systems, pay-as-you-go (PAYG) versus fully funded. While a fully funded pension system does not have any effect on aggregate savings if capital markets are perfect, aggregate savings fall significantly in a PAYG system. Since public pensions are likely to distort household labor supply decisions, we endogenize labor supply below. In addition, we extend the two-period model to a more realistic 70-period model in which the retirement period is smaller than the working period. Next, we derive the optimal amount of pensions in a PAYG system and study how the demographic transition and aging of the population affect the sustainability of social security. We also discuss the findings of the literature on quantitative pension studies in detail. Finally, we introduce the concept of fiscal space and point out its sensitivity with respect to the aging that takes place in many industrialized countries at present.
Burkhard Heer

7. Public Debt

During the 1980s and 1990s, we observed many public debt crises in Latin America and Asia. Prior to, during, and after the financial crisis of 2007–2008, we also observed many countries in the European Monetary Union (EMU) with severe public debt problems. Government debt has increased to unprecedented levels in the post-World War II era in the so-called “GIIPS” countries (Greece, Ireland, Italy, Portugal, and Spain). The Greek, Spanish, and Italian governments have had to pay premiums of 16, 3, and 3 percentage points on their public debt relative to Germany. Consequently, the president of the European Central Bank (ECB), Mario Draghi, initiated a program whereby the ECB extended 3-year loans in the amount of 1 trillion (!) euros to the Eurozone banking sector. Interest rates subsequently converged, but debt levels remain high and still amounted to 179%, 100%, and 132% of GDP in Greece, Spain, and Italy in 2015, almost 10 years after the onset of the crisis. As a second major second case of severe public debt, Japan had accumulated a gross public debt equal to approximately 240% of GDP by 2015.
Burkhard Heer


Additional information

Premium Partner

image credits