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Master Economics and Public Policy ECO 553. Economic Growth ^{1}

Lecture 5 Public policies in the neoclassical growth model

Pierre Cahuc

Winter 2013-2014

^{1} http://sites.google.com/site/eco553x/

1 / 47

Introduction

I We use the neoclassical growth model to analyze

1. Public debt

2. Distortionary taxation

2 / 47

1. Public debt

I Let us assume that there is a government that must Önance public expenditures g ( t ) 0 at time t 0

I The economy is competitive (same model as in lecture 4)

I For the sake of simplicity, public expenditures are not in the utility function of the households

I The valuation of public expenditure is implicit (public good, e.g. justice, police, army )

3 / 47

1. Public debt

I We can consider 2 di§erent situations

1. non distortionary taxation: lump sum taxes, independent of the income of the household

2. when taxes depend on income (capital income, labor income), they are distortionary

I We begin to analyze the consequence of public debt, i.e. Önancing of public expenditure with public deÖcit versus taxes, assuming that taxes are non distortionary

I Distortionary taxation is analyzed in the next section

4 / 47

1. Public debt

I Let us Örst assume that there is no public deÖcit, and then no public debt

I We look for the competitive equilibrium

I At time t , taxes paid by the representative household, denoted by τ ( t ) , are equal to public expenditure

τ ( t ) = g ( t )

I The instantaneous budget constraint of the household is

a˙ ( t ) = w ( t ) + r ( t ) a ( t ) g ( t ) c ( t )

(1)

5 / 47

1. Public debt

I The intertemporal budget constraint of the household is

^{Z} ∞

0

t

c ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt = h _{0} + a _{0} G _{0}

0

(2)

I h _{0} + a _{0} G _{0} is the wealth of the household

∞

I h _{0} = ^{R}

0

t

w ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt stands for the human capital

0

component of wealth

I a _{0} is the value of the assets at time t = 0

∞

I G _{0} = ^{R}

0

t

g ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt is the present value of taxes.

0

I Increases in taxes reduce the wealth of the household

6 / 47

1. Public debt

I The program of the household is

subject to

_{f} c ( t ) 0 , t 0 _{g} Z + ∞

max

0

u ( c ( t )) e ^{} ^{ρ} ^{t} dt

t

lim _{∞} a ( t ) e ^{} ^{R}

t !

0

a˙ ( t ) =

a ( 0 ) = a _{0}

w ( t ) + r ( t ) a ( t ) g ( t ) c ( t )

r ( x ) d x

_{=} _{0}

7 / 47

1. Public debt

I The solution of the maximization problem of the household yields the Keynes-Ramsey rule

( t ) ( t ) ^{=}

c˙

c

1

_{(} _{t} _{)}_{)} [ r ( t ) ρ ]

σ

( c

and the transversality condition

a ( t ) u ^{0} ( c ( t )) e ^{} ^{ρ} ^{t} = 0 _{∞}

lim

t !

as in the model without tax

I The behavior of the Örm is the same as in the model without tax:

r ( t ) = f |
(3) |

w ( t ) = f ( k ( t )) k ( t ) f |
(4) |

where k ( t ) = K ( t ) / L ( t ) .

8 / 47

1. Public debt

I Equilibrium on the labor market and on the capital market implies:

L ( t ) = 1, a ( t ) = k ( t )

I The equality a ( t ) = k ( t ) , the demand for labor and for capital (eq. (4) and (3)) allow us to write the instantaneous budget constraint of the household as follows

k ˙ ( t ) = f ( k ( t )) δ k ( t ) c ( t ) g ( t )

9 / 47

1. Public debt

I Finally, the competitive equilibrium path of f c ( t ) , k ( t ) , t 0 g is deÖned by

˙ |
||

k |
( t ) = |
f ( k ( t )) δ k ( t ) c ( t ) g ( t ) |

lim

t !

k ( t ) u ^{0} ( c ( t )) e ^{} ^{ρ} ^{t} = _{∞}

( t ) ( t ) ^{=}

c˙

c

0

1

_{(} _{t} _{)}_{)} [ f ^{0} ( k ( t )) δ ρ ]

σ

( c

k ( 0 ) = k _{0} > 0

10 / 47

1. Public debt

I Let us look at the steady state equilibrium

I Assume that g ( t ) = g > 0

I Steady state equilibrium value of ( k , c ) is deÖned by

f ^{0} ( k ) = ρ + δ

c = f ( k ) δ k g

I Public expenditures crowd out private consumption

I Public expenditures have no e§ect on the equilibrium steady state capital stock

11 / 47

1. Public debt

I The Solow model yields a di§erent prediction

I In the Solow model, the law of motion of k ( t ) is

k ˙ ( t ) = sf ( k ( t )) δ k ( t ) g ( t )

where s 2 ( 0, 1 ) denotes the saving rate of households

I In steady state:

sf ( k ) = δ k + g

I The Solow model implies that k and then y decrease with g

12 / 47

1. Public debt

I In the neoclassical model, the saving rate increases when public expenditures are increased because the marginal utility of consumption does not depend on public expenditures

I In the neoclassical model, the steady state equilibrium stock of capital does not depend on public expenditures

I The transitional dynamics of k ( t ) induced by an unanticipated shock which increases public expenditures from 0 to g > 0, is represented on the next Ögure

I k ( t ) = k ^{} if the economy is in the steady state initially

I If the economy is not in steady state initially, the transitional dynamics of k ( t ) depend on the properties of the instantaneous utility function

13 / 47

1. Public debt

c

dc/dt=0

c*

c * ’

dk/dt=0

k*

k

14 / 47

1. Public debt

I Let us now assume that there are public deÖcits Önanced with public debt

I The lump sum tax paid by the representative household τ ( t ) is not any more equal to g ( t )

I The public debt is denoted by b ( t )

I The instantaneous budget constraint of the government is

b ˙ ( t ) = g ( t ) τ ( t ) + r ( t ) b ( t )

˙

I b ( t ) is the current deÖcit of the budget of the government

15 / 47

1. Public debt

I One must also impose a No-Ponzi game condition to the government

lim _{∞} b ( t ) e ^{} ^{R}

t !

0

t r ( x ) d x _{=} _{0}

I The intertemporal budget constraint of the government is

b _{0} = Z ∞

0

t

_{[} τ ( t ) g ( t ) _{]} e ^{} ^{R}

0

r ( x ) d x _{d}_{t}

_{(}_{5}_{)}

I This equation shows that the discounted values of expenditures and taxes must reimburse the initial debt

I The instantaneous budget of the representative household is the same as before (see eq. (1)) except that τ ( t ) is substituted for g ( t )

a˙ ( t ) = w ( t ) + r ( t ) a ( t ) τ ( t ) c ( t )

16 / 47

1. Public debt

I But the capital market equilibrium is

a ( t ) = k ( t ) + b ( t )

because the assets of the household are made of

I the private bonds whose counterpart is the stock of capital of the Örms

I the public bonds whose counterpart is the public debt

17 / 47

1. Public debt

I Therefore, the intertemporal budget constraint of the household can be written as

^{Z} ∞

0

t

c ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt = h _{0} + k _{0} + b _{0} T _{0}

0

(6)

I h _{0} + b _{0} + k _{0} T _{0} is the wealth of the household

∞

I h _{0} = ^{R}

0

t

w ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt stands for the human capital

0

component of the wealth

I b _{0} is the value of the public bonds at time t = 0

I k _{0} is the stock of capital of the Örms at time t = 0

∞

I T _{0} = ^{R}

0

t

τ ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt is the present value of taxes

0

18 / 47

1. Public debt

I Using the intertemporal budget constraint of the government

(5):

b 0 = _{Z} _{∞}

0

_{[} τ ( t ) g ( t ) _{]} e ^{} ^{R}

0

t r ( x ) d x _{d}_{t}

we can write the intertemporal budget constraint of the household (6):

^{Z} ∞

0

as follows:

c ( t ) e ^{} ^{R}

t ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt =

0

h _{0} + k _{0} + b _{0} T _{0}

^{Z} ∞

0

t

c ( t ) e ^{} ^{R} ^{r} ^{(} ^{x} ^{)} ^{d} ^{x} dt = h _{0} + k _{0} G _{0}

0

(7)

which is identical to equation (2) with a _{0} = k _{0} .

19 / 47

1. Public debt

I Therefore, the budget constraint of the household is independent of the level of public debt

I The impact of public expenditures, f g ( t ) , t 0 g on the consumption of households and on the evolution of the stock of capital is independent of the path of public debt

f b ( t ) , t 0 g

I The saving behavior of the household neutralizes the e§ect of the public debt

I Neutrality of public debt, Ricardo equivalence, Barro equivalence

20 / 47

1. Public debt

I The neutrality of public debt relies on strong assumptions:

I perfectly rational households

I optimization over an inÖnite time horizon

I perfect credit market

I non distortionary taxation

I Actually, public debt is not neutral, but empirical studies Önd there is a negative correlation between public saving and private saving ^{2}

^{2} see for instance Luiz de Mello, Per Mathis Kongsrud and Robert Price, 2004, Saving Behaviour and the E§ectiveness of Fiscal Policy , OCDE, Economic Department paper, 397.

21 / 47

2. Distortionary taxation

I Until now, it has been assumed that taxes did not depend on:

1. capital income

2. labor income

I Study of distortionary taxation on labor income:

I the distortion is empirically important

I can be studied with models that include labor supply

22 / 47

2. Distortionary taxation

I Measure of distortion: tax wedge

I Let W and P _{f} respectively be the nominal wage received by an employee and the producer price index.

I t _{f} the average rate of mandatory deductions from wages borne by Örms

I The real labor cost for the employer is written:

_{w} f _{=} W ( 1 + t _{f} )

P

f

23 / 47

2. Distortionary taxation

I Denote by t _{c} and t _{e} respectively the average rate of indirect taxes on consumption and the average rate at which earned income is taxed, net of beneÖts received

I Let P _{c} represent the consumer price index exclusive of consumption taxes.

I The purchasing power of an employee takes the form:

_{w} e _{=} W ( 1 t _{e} )

P _{c} ( 1 + t _{c} )

Eliminating the nominal wage W between the expressions of w _{e} and w _{f} , we get:

_{w} f _{=} _{τ} _{w} e

_{w}_{i}_{t}_{h} _{τ} _{=} ( 1 + t _{c} )( 1 + t _{f} )

( 1 t _{e} )

^{} P c

P

f

(8)

24 / 47

2. Distortionary taxation

I The term τ deÖnes the wedge ; it measures the ratio between the cost of labor borne by the employer and the purchasing power of wages.

I The wedge has two components.

1. ( P _{c} / P _{f} ) , which is ináuenced by the price of imports, because P _{c} comprises import prices, whereas the producer price index only comprises prices of domestic goods (which can however be indirectly ináuenced by import prices).

2. The tax wedge, which hinges on the tax rates t _{c} , t _{e} and t _{f} .

I Henceforth, we will focus only on the tax wedge by setting the ratio ( P _{c} / P _{f} ) equal to one.

25 / 47

2. Distortionary taxation

Tax wedge around 2005. The black bar represents the tax wedge without consumption taxes. Source: OCDE

26 / 47

2. Distortionary taxation

27 / 47

2. Distortionary taxation

Direct taxes on earned income (income tax plus employeesíand employersícontributions), for a single person with no children paid at 100 percent of the average wage.

28 / 47

2. Distortionary taxation

I There are huge cross country di§erences

I Edward Prescott, 2004, ìWhy Do Americans Work So Much More than Europeans.", Federal Reserve Bank of Minneapolis, issue July, pp. 2-13.

29 / 47

2. Distortionary taxation

Taxes on labor income and weekly hours worked per individuals in the age range 15-64 in 1970-1974 and 1993-1996. Source: Prescott (2004)

E§ective marginal tax rate = (t _{c} + t _{e} + t _{f} ) / ( 1 + t _{c} ) () fraction of labor income that is extracted in the form of taxes.

30 / 47

2. Distortionary taxation

Taxes on labor income and annual hours worked in 15 OECD countries over the period 1970-2010. Each dot corresponds to a year-country observation. Source McDaniel (2011 and www.caramcdaniel.com) and OECD.

31 / 47

2. Distortionary taxation

I In order to show that di§erences in hours worked across countries may reáect di§erences in taxation, Prescott uses a model of intertemporal labor supply

I We present here a static version that highlights the main thrust of the argument.

I The static version corresponds to the steady state of the neoclassical growth model

I We shall Örst remind the issue of tax incidence and then analyze the impact of taxes on hours worked

32 / 47

2. Distortionary taxation

I Let us consider a competitive economy where the marginal productivity of labor is F _{L} ( K , L ) , where L denotes the quantity of labor

I Firms pay a payroll tax denoted by T _{f} so that their marginal proÖt per employee is equal to F _{L} ( K , L ) w T _{f} where w denotes the real gross wage.

I At competitive equilibrium, proÖt maximization implies that

w = F _{L} ( K , L ) T _{f} .

I Workers pay taxes T _{e} so that their net wage, w _{e} , is equal to

w T _{e} .

I Accordingly, the net wage is

w _{e} = F _{L} ( K , L ) T _{f} T _{e}

33 / 47

2. Distortionary taxation

I In steady state, we have shown that F _{K} ( K , L ) = r + δ , with r = ρ , which implies f ^{0} ( k ) = ρ + δ where k = K / L

I Therefore we get

w _{e} = F _{L} ( k , 1 ) T _{f} T _{e}

where k is determined by f ^{0} ( k ) = ρ + δ .

34 / 47

2. Distortionary taxation

I Equation

w _{e} = F _{L} ( k , 1 ) T _{f} T _{e} shows two important properties

1. First, the impact of taxes on the net wage is identical, whether it is the employer or the employee who is paying taxes to the Ösc.

2. Second, a $1 tax on labor induces a $1 decrease in the net wage.

I This result holds good in a framework where the marginal productivity of labor is constant, so that labor demand is inÖnitely elastic with respect to the wage.

I In steady state with constant returns to scale, the marginal productivity of labor is independent of the quantity of labor L because Örms adjust the stock of capital to keep the capital/labor ratio k constant when the quantity of labor changes.

35 / 47

2. Distortionary taxation

I It should be noted that empirical evaluations of the incidence of taxes generally Önd that changes in taxes have a strong impact on net wages, which move in the direction opposite to that of the taxes.

I These Öndings suggest that using a model where a $1 tax on labor induces a $1 decrease in net wage can be an acceptable approximation in the long run

I This is certainly one of the reasons why the theory of optimal taxation, stemming from the seminal paper of Mirrlees (1971) makes, in most cases, such an assumption (see Piketty and Saez, 2013)

I Henceforth, we will assume, without loss of generality, that F _{L} ( k , 1 ) = 1 for the sake of simplicity.

36 / 47

2. Distortionary taxation

I The preferences of the representative individual are described by the utility function:

U = log c + α log ( 1 h )

where c and h designate consumption and hours worked, or more precisely the proportion of disposable time dedicated to working.

I The parameter α > 0 speciÖes the value of leisure time for the household

I Each unit of labor produces one unit of good, which implies, together with the zero proÖt condition, that the wage is equal to 1, assuming that Örms pay no tax.

I Taxes on consumption and on labor earnings are assumed to be proportional for the sake of simplicity.

37 / 47

2. Distortionary taxation

I The budget constraint of the consumer is

( 1 + τ _{c} ) c = h ( 1 τ _{h} ) + T

(9)

where τ _{c} and τ _{h} stand respectively for consumption tax rate and the rate of tax on labor earnings, and T denotes lump sum transfers from the government.

I The budget constraint (9) gives the value of c as a function of

h .

38 / 47

2. Distortionary taxation

I Carrying this value into the utility function U and deriving with respect to h , we Önd that the optimal value of h veriÖes:

( 1 τ _{h} )

h ( 1 τ _{h} ) + T ^{} ^{α}

1

_{1} _{} _{h} = 0 ()

1

τ _{h}

1

+

τ _{c}

^{1}

= α

c 1 h

I This equation may also be written:

where

( 1 τ ) = 1 ^{α} ^{c}

_{h}

_{τ}

_{=} _{τ} _{c} _{+} _{τ} _{h}

1 + τ _{c}

(10)

(11)

is the e§ective marginal tax rate on labor income, which is the fraction of labor income that is extracted in the form of taxes.

39 / 47

2. Distortionary taxation

I The budget constraint of the government implies that lump

sum transfers T are equal to tax receipts, which implies that

T = τ _{c} c + h τ _{h} .

I Using the budget constraint (9) of the household, we Önd that c = h , i.e. that consumption equals labor income.

I Substituting this equality into (10), we get the equilibrium number of hours worked:

h

=

α

1 + 1 .

1 τ

(12)

I This equation shows that the duration of hours worked does decrease with the e§ective marginal tax rate.

40 / 47

2. Distortionary taxation

I Prescott computes the average across-country value of τ and sets the value of α equal to 1.54, in order to match the average number of weekly hours worked in the model with the actual average value for the G7 countries.

I This allows him to argue that across-country variation in taxes explains most of the di§erences in hours worked.

I A question that arises is whether the elasticity of labor supply implied by the calibrated model is compatible with the usual microestimates of the elasticity of labor supply.

41 / 47

2. Distortionary taxation

I The literature distinguishes 3 types of labor supply elasticity

1. Marshall, or uncompensated

I max U subject to the budget constraint

I income and substitution e§ects

2. Hicks, or compensated

¯

I min expenditure subject to U U

I substitution e§ects only

3. Frisch

I constant marginal utility of wealth

I temporary changes in labor income

42 / 47

2. Distortionary taxation

I In the model of Prescott,

I permanent changes in taxes

I compensated by changes in transfers, implying that changes in taxes have no income e§ects.

I Hicksian elasticity of labor supply

I Equation (12) allows us to compute the Hicksian elasticity of labor supply with respect to net labor income ( 1 τ ) , equal to:

d log h

α

d log ( 1 τ ) ^{=} α + 1 τ ^{.}

43 / 47

2. Distortionary taxation

I In the data of Prescott,

I the average value of 1 τ amounts to 0.53.

I α equal to 1.54.

I Accordingly, the Hicksian elasticity of labor supply predicted by the model is about 0.74

I This is only a little greater than usual estimated values of the Hicksian elasticity which is about 0.5

I Hence the model Öts the data surprisingly well in this dimension

I Results on Frischian elasticity are less convincing (see tutorial)

44 / 47

2. Distortionary taxation

I What are the lessons of this exercise?

I Prescott instructs us that di§erences between countries in the taxation of labor income can explain large di§erences in hours worked, for verisimilar values of the Hicksian elasticity of labor supply.

I However, the macro elasticity of hours worked depends on the composition of the population, which can comprise demographic groups with very heterogeneous behaviors, as stressed by Blundell et al. (2013).

45 / 47

2. Distortionary taxation

I In practice , the impact of taxes on hours worked depends on the bundle of features of each separate Öscal system, for there is a wide range of average and marginal rates varying with amount and kind of income, and with types of households and their share in the population.

I In light of this, it would be erroneous to conclude that a country with a higher e§ective marginal tax rate on labor income, measured as it is in Prescottís type of study ñ that is, as an average value ñ has a tax system that is necessarily more detrimental to the supply of hours worked.

46 / 47

References

Blundell, R., Bozio, A. and Laroque, G., (2013), ìExtensive and intensive margins of labour supplyî, Fiscal Studies, 34(1), pp. 1-29. Chetty R., Guren, A., Manoli, D. and Weber, A. (2011), ìAre Micro and Macro Labor Supply Elasticities Consistent? A Review of Evidence on the Intensive and Extensive Marginsî, American Economic Review, Papers and Proceedings, 101, pp. 471-475. McDaniel, C. (2011), "Forces Shaping Hours Worked in the OECD, 1960-2004", American Economic Journal: Macroeconomics, 3(4), pp.

27-52.

Mirrlees, J. (1971), ìAn Exploration in the Theory of Optimum Income Taxationî, Review of Economic Studies, 38, pp. 175-208. Prescott, E. (2004), "Why do Americans work so much more than Europeans?", Federal Reserve Bank of Minneapolis Quarterly Review, 28(1), pp. 2ñ13. Piketty, T. and Saez, E., (2013), "Optimal Labor Income Taxation", in Handbook of Public Economics, edited by Auerbach, A., Chetty, R., Feldstein, M. and Saez, E., Volume 5, pp. 391-474

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