Public Finance in an Overlapping Generations Economy

The overlapping generations growth model is a very general analytical framework from which one can launch a multitude of economic studies. In this chapter, we will establish how we will employ it throughout all our subsequent analyses. Perhaps, one of the model’s most important aspects is its economic time frame. Here, we apply a two-period lifecycle growth model. This model was originally proposed by Diamond (1965), and since that time has been employed by many researchers due to its well-suited generalization enabling many simplifications. In this chapter, the dynamic properties of the model are focused on as they are pivotal in investigating the effects of capital accumulation on each generation’s welfare during the ensuing transition and in the long run. Policy implications of the modified golden rule and golden rule are explained and, following this, the applicability of the basic framework is extended in scope by including an endogenous labor supply, bequests, and a multi-period setting.

In Chapter 3, we investigate normative aspects of tax policy in an overlapping generations growth model. The set of commodity taxes that minimizes the deadweight loss is called Ramsey taxes. The Ramsey rule has a simple form (see Chapter 1). Under certain simplifying conditions, Ramsey taxes are proportional to the sum of the reciprocal of the elasticity of demand and supply. The tax rate should be set so that the increase in deadweight loss per extra dollar raised is the same for each commodity. The Ramsey rule is a useful criterion for static efficiency. In Chapter 2, on the other hand, we have shown that the golden rule is a useful criterion for dynamic efficiency. Thus, this chapter investigates the relationship between the Ramsey rule and the golden rule when lump-sum taxes are not available in the overlapping generations growing economy.

This chapter summarizes several simulation studies on tax reform using multi-period overlapping generations models. Based on Summers (1981b), we first formulate a bench mark model in which many generations coexist at any instant. The quantitative relationship between savings and the interest rate is complex and depends on all of the other parameters in the model. Section 2 compares the simulation results of Summers with Evans (1983).

In this chapter, we investigate positive and normative effects of public spending. Most of the previous literature on government expenditure has investigated the effect of public spending financed by lump-sum taxes (or wage income taxes with exogenous labor supply). The conventional view is that an increase in public spending, which will not contribute to stimulating production has a negative impact on capital formation due to the resource withdrawal effect.

This chapter extends the basic model into a two-country framework. Since the work of Feldstein (1978), Bradford (1980a, 1980b), Mieskowski (1980), and Summers (1981b) among others, the consumption tax policy has gained considerable support in the last decade or so. Section 2 demonstrates the results of the conventional wisdom. In an open economy, a switch from the income tax to the consumption tax increases capital accumulation, reduces the interest rate, and improves welfare in the world-wide economy. Next, this section investigates the positive spillover welfare effect of tax reform in the home country on the foreign country. Since our main concern in this chapter is to extend the results in previous chapters into a two-country open-economy framework, for simplicity we will mainly consider the long-run properties.

This chapter introduces money into the basic model. There are two views of money. In the ‘bubbly’ view, money is a pure store of value. This view implies that price of money grows at the real rate of interest and that money is held entirely for speculation. In the ‘fundamentalist’ view money is held to finance transactions. Only the fundamentalist view can explain the rate of return dominance of other assets over money. Samuelson (1958) first introduced money into the overlapping generations model. Section 2 summarizes his framework without capital accumulation¹ and explains the bubbly view of money. We also introduce money into the Diamond model with capital accumulation and explain the fundamentalist view of money by examining the dynamic properties of the economy as well as its steady state nature.

It has been assumed that consumption goods and investment goods are perfect substitutes as the outputs of production technology. In reality, however, a significant fraction of savings is invested in assets that has a very long life and are not easily substitutable with consumption.

In Chapter 9 we introduce government debt into the basic model. We first show that the tax-financed transfer payments and Diamond’s debt have the same effect on the long-run equilibrium. We also show that if lump-sum taxes are appropriately adjusted, debt policy is not effective and hence the government deficit is a meaningless policy indicator. We then examine the burden of debt and show that an increase in a constant amount of government debt per worker will crowd out capital accumulation in the long run. Section 2 also analyzes economic activities of government by introducing government capital.

It is well known that in unfunded social security systems, the contributions of the younger generation earn a return which is composed of the rates of growth of population (biological rate of interest) and wages. Whereas for funded social security systems, the market rate of interest and, thus, the marginal productivity of capital are relevant. From this perspective, it comes as no surprise that many industrial countries introduced or expanded pay-as-you-go unfunded public pension schemes in the years following the post-war baby boom. Considering the recent decline in the birth rates in an aging economy, however, a reverse transition seems inevitable.

It seems possible to argue that the class of infinitely-lived models is too narrow to accommodate some forms of intergenerational heterogeneity. In particular, it is impossible to understand the effect of intergenerational income redistribution on growth. This is one of the main reasons why we have used the overlapping generations model in this book. However, it is also impossible to understand the long-run effect on the growth rate, where the long-run growth rate is exogenously given, in the standard overlapping generations model as developed in the previous chapters.