Wealth Effects and Public Debt in an Endogenous Growth Model. Banca d'Italia Public Finance Workshop 'Fiscal Sustainability : Analytical Developments and Emerging Policy Issues', Perugia, 3-5 April 2008

Abstract

The debate on public finances' sustainability has long focused on the conditions for the accumulation of debt. This implied that, empirically, the analyses revolved around estimations of dynamic versions of the debt accumulation equation, through unit root tests and cointegration tests between e.g. revenues and primary expenditures, or debt and deficit. Bohn (2007, Journal of Monetary Economics), has forcefully argued in favour of a stronger focus on theory. The model of this paper shows to which extent and under which conditions earlier results considering fiscal policy in an endogenous growth setting are modified if government spending is not entirely tax-financed. Therefore the model uses Barro's (1990, Journal of Political Economy) production function and Blanchard (1985, Journal of Political Economy)-type consumers to assess fiscal sustainability and the determinants of long-run (or potential) growth, in presence of productive capital services. The main conclusion is that, provided public spending is not too high, it will be growth-enhancing. This feature does not hurt fiscal sustainability if taxes are adjusted appropriately. We also calibrate the model to show that the current level of public capital is low in France, the UK and the USA.