ECOM-G313: Macroeconomics 2

Fiscal Policy

Timm Prein

Autumn 2024

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Government Budget

Government expenditures:
Gt = Purchases of Goods + Wages and Salaries + Public
Investments + other

Net taxes:
Tt = Taxes + Social insurance contributions + Other receipts −
Social insurance transfers − Subsidies

Net interests:
rt−1 Bt−1

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Government Budget Constraint in a Two-Period Model

Period t (today):
Gt = Tt + Bt
Period t + 1 (tomorrow):

Gt+1 + rt Bt = Tt+1 + Bt+1 − Bt

Notes:
Sign convention: Bt > 0 is debt, Bt < 0 implies government is saving

Gt − Tt is often called primary goverment deficit and

Gt + rt−1 Bt−1 − Tt goverment deficit.

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Government Budget Constraint in a Two-Period Model

Terminal condition: Bt+1 = 0

Combine the two budget constraints to get an intertemporal budget

constraint:
Gt+1 Tt+1
Gt + = Tt +
1 + rt 1 + rt
Present discounted stream of spending equals present discounted
stream of tax revenues.
→ Budget must be balanced in present value sense, but not
necessarily Gt = Tt and Gt+1 = Tt+1

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Government Budget Constraint - Infinite Horizon

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 5 / 24

Government Budget Constraint - Infinite Horizon

Period 1:
G1 = T1 + B1
Period 2:
G2 + (1 + r1 )B1 = T2 + B2

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Government Budget Constraint - Infinite Horizon

Period 1:
G1 = T1 + B1
Period 2:
G2 + (1 + r1 )B1 = T2 + B2

Solving the period 2 constraint for B1 and plugging into the period 1
budget constraint:
T2 + B2 − G2
G1 = T1 +
1 + r1
or
G2 T2 B2
G1 + = T1 + +
1 + r1 1 + r1 1 + r1

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Government Budget Constraint - Infinite Horizon
Iterate it T periods:

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 6 / 24

Government Budget Constraint - Infinite Horizon
Iterate it T periods:
G2 G3 GT
G1 + + + ... + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k )
T2 T3 TT BT
= T1 + + + ... + QT −1 + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k ) k=1 (1 + rt+k )

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 6 / 24

Government Budget Constraint - Infinite Horizon
Iterate it T periods:
G2 G3 GT
G1 + + + ... + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k )
T2 T3 TT BT
= T1 + + + ... + QT −1 + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k ) k=1 (1 + rt+k )

More compactly and assuming that the government cannot die in

debt and will not find it optimal to leave savings, s.t. BT = 0:

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 6 / 24

Government Budget Constraint - Infinite Horizon
Iterate it T periods:
G2 G3 GT
G1 + + + ... + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k )
T2 T3 TT BT
= T1 + + + ... + QT −1 + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k ) k=1 (1 + rt+k )

More compactly and assuming that the government cannot die in

debt and will not find it optimal to leave savings, s.t. BT = 0:
T T
X Gt X Tt
Qt−1 = Qt−1
t=1 k=1 (1 + rt+k ) t=1 k=1 (1 + rt+k )

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 6 / 24

Government Budget Constraint - Infinite Horizon
Iterate it T periods:
G2 G3 GT
G1 + + + ... + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k )
T2 T3 TT BT
= T1 + + + ... + QT −1 + QT −1
1 + r1 (1 + r1 )(1 + r2 ) k=1 (1 + rt+k ) k=1 (1 + rt+k )

More compactly and assuming that the government cannot die in

debt and will not find it optimal to leave savings, s.t. BT = 0:
T T
X Gt X Tt
Qt−1 = Qt−1
t=1 k=1 (1 + rt+k ) t=1 k=1 (1 + rt+k )

Then it holds at the infinite horizon that

∞ ∞
X Gt X Tt
Qt−1 = Qt−1 .
t=1 k=1 (1 + rt+k ) t=1 k=1 (1 + rt+k )

Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 6 / 24

Some Questions concerning Fiscal Policy
Some of the most interesting and important discussions in
macroeoconomics concerns the status of government debt.

If I hold government debt, can I really include it in my wealth?

Eventually I have to pay taxes to the government for it to be able to

pay back the debt (with interest) to me.

The present value of my tax liabilities then equals the value of

government debt in my hands now: I cannot be wealthier by holding
the debt.

Is this correct?

And if it is, does it have implications for the possibilities of the

government to affect aggregate demand through changes in its
expenditure?
Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 7 / 24
Fiscal Policy in an Endowment Economy
We extend the 2-period endowment economy from Lecture 2.

Representative household with standard lifetime utility function.

Household’s budget constraints:

ct + st = yt − Tt

ct+1 = yt+1 − Tt+1 + (1 + rt )st

where Tt denotes lump-sum taxes in period t.
Intertemporal budget constraint:
ct+1 yt+1 − Tt+1
ct + = yt − Tt +
1 + rt 1 + rt
where yt − Tt denotes net income in period t. yt is now gross
(pre-tax) income.
Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 8 / 24
Fiscal Policy in an Endowment Economy

Government collects taxes Tt and consumes Gt in period t.

Public debt is B. Assume no default risk (by the government).

Period t and t + 1 budget constraints of the government:

Gt = Tt + Bt

Gt+1 + rt Bt = Tt+1 + Bt+1 − Bt

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Fiscal Policy in an Endowment Economy

We derive the public sector intertemporal budget constraint like the

household budget constraint
Gt+1 Tt+1
Gt + = Tt + .
1 + rt 1 + rt
Implications:
The present value of the public expenditure must be equal to the
present value tax revenues.
If the period t budget is in deficit Gt > Tt , the second period budget
must have surplus. (And vice versa. E.g., if taxes are reduced by one
unit (∆Tt = −1) in the first period, then taxes must be (1 + r )∆Tt
units higher in the second period t + 1.)

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Ricardian Equivalence

Reduce the taxes in the first period by ∆T1 and add them in period t + 1
by ∆T1 (1 + r ):

ct+1 yt+1 − [Tt+1 + (1 + rt )∆T1 ]

ct + = yt − (Tt − ∆T1 ) + .
1 + rt 1 + rt
that reduces to
ct+1 yt+1 − Tt+1
ct + = yt − Tt + .
1 + rt 1 + rt
The change in the timing of taxes has no impact on the households’
intertemporal budget constraint!

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Ricardian Equivalence

Substitute the government budget constraint into the households’ budget

constraint

ct+1 yt+1 − Tt+1

ct + = yt − Tt +
1 + rt 1 + rt
yt+1 Gt+1
= yt + − Gt − . (1)
1 + rt 1 + rt
Implications:
The structure of funding of government expenditures does, thus, not
matter for consumption choices ct and ct+1 .

What matters for the consumer is only the present value of

government expenditure flows. Government bonds are not net wealth
and do not affect consumer behaviour.

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Ricardian Equivalence

Thus, if government spending is unchanged (Gt , Gt+1 , ...) and only

the timing of taxes changes without effect on the present discounted
value of taxes paid by each household, then aggregate consumption
does not change in any period.

Note that while consumption does not change, saving does change!

You can consider Ricardian equivalence as the Modigliani-Miller

-theorem as applied to the public sector funding.

Ricardian Equivalence holds in the basic versions of the Real Business

Cycle (RBC) and New-Keynesian models.

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Ricardian Equivalence - Applied
In recent years there has been a claim that if Ricardian Equivalence
holds then temporary debt financed increases in government
expenditure cannot increase aggregate demand.
Assume that in period t the government increases its expenditure by
dGt > 0 while keeping the present value of government expenditure
flows unchanged, i.e. dGt+1 = −(1 + r )dGt .
Then (1) then implies that the consumer behavior is not affected at
all, dC1 = dC2 = 0.
The change in aggregate demand equals the sum of changes in
private consumption and government expenditure:
dCt + dGt = 0 + dGt = dGt > 0
and aggregate demand increases by the amount of government
expenditure.
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Ricardian Equivalence - Limitations

For an individual consumer, her discounted tax liabilities need not

match the value of government debt she holds: Distributional issues.

What if taxes are distortionary and not lump-sum as assumed above?

Governments typically can borrow at interest rates lower than private

agents (consumers, firms) or at least at cheaper rates than most of
private actors. Implications?

Capital market imperfections may have an effect, e.g. if private sector

is credit constrained.

No generational distribution of debt burden.

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Consumption, Labor and Income Taxation

We study the taxation issue using a simple two-period consumption and

labour supply model with the following modifications:

Households only work in the first period.

In the second period, they retire but receive a lump-sum transfer

(social security benefit) b ≥ 0.

They pay proportional tax τc1 on their first period consumption and
τc2 on the second period consumption.

They pay proportional tax τl on their labour income (only in the first
period when they work).

They pay proportional tax τs on the return from their savings (tax at
source).

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A Two-Period Model of Taxation

The household’s maximization problem becomes

max log(ct ) + θ log(1 − n) + β log(ct+1 )

ct ,ct+1 ,s,n

subject to
(1 + τc1 )ct + s = (1 − τl )wn (2)
(1 + τc2 )ct+1 = (1 + (1 − τs )r )s + b, (3)

where θ measures how much household value leisure.

As before, solve (3) for s

(1 + τc1 )ct+1 − b
s=
(1 + r (1 − τs ))

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A Two-Period Model of Taxation

and substitute it into (2) to obtain intertemporal budget constraint

(1 + τc2 )ct+1 b
(1 + τc1 )ct + = (1 − τl )wn + .
(1 + r (1 − τs )) (1 + r (1 − τs ))

Since we want to derive the first-order condition wrt 1 − n, lets write above
such that we have 1 − n everywhere using the definition n = 1 − (1 − n).

(1 + τc2 )ct+1 b
(1 + τc1 )ct + = (1 − τl )w (1 − (1 − n)) +
(1 + r (1 − τs )) (1 + r (1 − τs ))
or
(1 + τc2 )ct+1 b
(1+τc1 )ct + +(1−τl )w (1−n) = (1−τl )w + .
(1 + r (1 − τs )) (1 + r (1 − τs ))

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A Two-Period Model of Taxation
The Lagrangian

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A Two-Period Model of Taxation
The Lagrangian

L = log(ct ) + θ log(1 − n) + β log(ct+1 )

 b
+ λ (1 − τl )w +
(1 + r (1 − τs ))
(1 + τc2 )ct+1 
− (1 + τc1 )ct − − (1 − τl )w (1 − n)
(1 + r (1 − τs ))

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A Two-Period Model of Taxation
The Lagrangian

L = log(ct ) + θ log(1 − n) + β log(ct+1 )

 b
+ λ (1 − τl )w +
(1 + r (1 − τs ))
(1 + τc2 )ct+1 
− (1 + τc1 )ct − − (1 − τl )w (1 − n)
(1 + r (1 − τs ))
The first-order conditions are given by

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A Two-Period Model of Taxation
The Lagrangian

L = log(ct ) + θ log(1 − n) + β log(ct+1 )

 b
+ λ (1 − τl )w +
(1 + r (1 − τs ))
(1 + τc2 )ct+1 
− (1 + τc1 )ct − − (1 − τl )w (1 − n)
(1 + r (1 − τs ))
The first-order conditions are given by
∂L 1
= − λ(1 + τc1 ) = 0
∂ct ct
∂L β (1 + τc2 )
= −λ =0
∂ct+1 ct+1 1 + r (1 − τs )
∂L θ
= − λ(1 − τl )w = 0
∂(1 − n) 1−n
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A Two-Period Model of Taxation
or
1
= λ(1 + τc1 ) (4)
ct
β (1 + τc2 )
=λ (5)
ct+1 1 + r (1 − τs )
θ
= λ(1 − τl )w (6)
1−n

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A Two-Period Model of Taxation
or
1
= λ(1 + τc1 ) (4)
ct
β (1 + τc2 )
=λ (5)
ct+1 1 + r (1 − τs )
θ
= λ(1 − τl )w (6)
1−n
Solve λ from (4) and substitute it to (5) to obtain
βct (1 + τc2 ) 1
=
ct+1 (1 + τc1 ) 1 + r (1 − τs )
and to (6) to obtain
θct (1 − τl )w
= .
1−n 1 + τc1
Timm Prein ECOM-G313: Macroeconomics 2 Autumn 2024 20 / 24
A Two-Period Model of Taxation - Notes

Increase in τs reduces after-tax interest rate 1 + r (1 − τs )

→ household will consume more on the first period.

Increase in the first period consumption taxes τc1 reduces households’

consumption in the first period (relative to consumption in the second
period).

Increase in the second period consumption taxes τc2 increases

households’ consumption in the first period (relative to consumption
in the second period).

Increase in labour taxes τl reduces after-tax wage rate and reduces

consumption relative to leisure, ie c1 /(1 − n) falls. This substitution
effect reduces both the first period consumption and labour supply.

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A Two-Period Model of Taxation - Notes

An increase in the first period consumption taxes τc1 reduces

consumption relative to leisure. This is the substitution effect saying
that an increase in τc1 reduces both current period consumption and
labour supply.

Assume a tax system where τl = 0 and τc1 = τc2 = τc . Then, there

exists a labour income tax τl and a lump sum tax T such that for
τc = 0 household finds it optimal to make exactly the same
consumption choices as before.

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Why do Americans work so much more than Europeans?

See original article and some other explanations and some Finnish
calculations (page 87–94).
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References

Garín, Julio, Robert Lester and Eric Sims (2021), Intermediate

macroeconomics, Chapter 13.
https://juliogarin.com/files/textbook/GLS_Intermediate_
Macro.pdf

Lecture Notes by Dirk Krueger (UPenn): “Dynamic Fiscal Policy”,

Ch.4.
https://www.sas.upenn.edu/~vr0j/oldteaching/244-19/
PennFiscalNew.pdf

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