Master Economics and Public Policy

ECO 553. Economic Growth1

Lecture 5
Public policies in the neoclassical growth model
Pierre Cahuc

Winter 2013-2014

1 http://sites.google.com/site/eco553x/
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Introduction

We use the neoclassical growth model to analyze

1. Public debt
2. Distortionary taxation

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1. Public debt

Let us assume that there is a government that must nance

public expenditures g (t ) 0 at time t 0

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

For the sake of simplicity, public expenditures are not in the

utility function of the households

The valuation of public expenditure is implicit (public good,

e.g. justice, police, army...)

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1. Public debt

We can consider 2 dierent 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

We begin to analyze the consequence of public debt, i.e.

nancing of public expenditure with public decit versus
taxes, assuming that taxes are non distortionary

Distortionary taxation is analyzed in the next section

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1. Public debt

Let us rst assume that there is no public decit, and then no

public debt

We look for the competitive equilibrium

At time t, taxes paid by the representative household, denoted

by (t ), are equal to public expenditure
(t ) = g (t )

The instantaneous budget constraint of the household is

a (t ) = w (t ) + r (t )a(t )

g (t )

c (t )

(1)

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1. Public debt

The intertemporal budget constraint of the household is

Z
0

I
I
I
I
I

c (t )e

Rt
0

r (x )dx

dt = h0 + a0

G0

(2)

h0 + a0 G0 is the wealth of the household

Rt
R
h0 = 0 w (t )e 0 r (x )dx dt stands for the human capital
component of wealth
a0 is the value of the assets at time t = 0
Rt
R
G0 = 0 g (t )e 0 r (x )dx dt is the present value of taxes.
Increases in taxes reduce the wealth of the household

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1. Public debt

The program of the household is

max

Z +

fc (t ) 0,t 0 g 0

u (c (t ))e

dt

subject to
a (t ) = w (t ) + r (t )a(t )
lim a(t )e

t !

Rt
0

g (t )

c (t )

a ( 0 ) = a0
r (x )dx

= 0

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1. Public debt
I

The solution of the maximization problem of the household

yields the Keynes-Ramsey rule
c (t )
1
=
[r (t )
c (t )
(c (t ))

and the transversality condition

lim a(t )u 0 (c (t ))e

t !

=0

as in the model without tax

The behavior of the rm is the same as in the model without
tax:
r (t ) = f 0 (k (t ))
w (t ) = f (k (t ))

(3)

k (t )f (k (t ))

(4)

where k (t ) = K (t )/L(t ).
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1. Public debt

Equilibrium on the labor market and on the capital market

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

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 ))

k (t )

c (t )

g (t )

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1. Public debt

Finally, the competitive equilibrium path of

fc (t ), k (t ), t 0g is dened by
k (t ) = f (k (t ))
0

lim k (t )u (c (t ))e

t !

c (t )
c (t )

k (t )

c (t )

g (t )

= 0
=

1
[f 0 (k (t ))
(c (t ))
k (0) = k0 > 0

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1. Public debt

Let us look at the steady state equilibrium

Assume that g (t ) = g > 0

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

f 0 (k ) = +
c

= f (k )

Public expenditures crowd out private consumption

Public expenditures have no eect on the equilibrium steady

state capital stock

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1. Public debt

The Solow model yields a dierent prediction

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

k (t ) = sf (k (t ))

k (t )

g (t )

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

In steady state:

sf (k ) = k + g
I

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

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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

In the neoclassical model, the steady state equilibrium stock

of capital does not depend on public expenditures

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 gure
I
I

k (t ) = k if the economy is in the steady state initially

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

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1. Public debt
c
dc/dt=0

c*
c *

dk/dt=0

k*

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1. Public debt

Let us now assume that there are public decits nanced with
public debt

The lump sum tax paid by the representative household (t )

is not any more equal to g (t )

The public debt is denoted by b (t )

The instantaneous budget constraint of the government is

b (t ) = g (t )

(t ) + r (t )b (t )

b (t ) is the current decit of the budget of the government

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1. Public debt
I

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

government
Rt
lim b (t )e 0 r (x )dx = 0
t !

The intertemporal budget constraint of the government is

b0 =

Z
0

[ (t )

g (t )] e

Rt
0

r (x )dx

dt

(5)

This equation shows that the discounted values of

expenditures and taxes must reimburse the initial debt

The instantaneous budget of the representative household is

the same as before (see eq. (1)) except that (t ) is
substituted for g (t )
a (t ) = w (t ) + r (t )a(t )

(t )

c (t )
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1. Public debt

But the capital market equilibrium is

a (t ) = k (t ) + b (t )
because the assets of the household are made of
I
I

the private bonds whose counterpart is the stock of capital of

the rms
the public bonds whose counterpart is the public debt

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1. Public debt
I

Therefore, the intertemporal budget constraint of the

household can be written as
Z
0

I
I
I
I
I

c (t )e

Rt
0

r (x )dx

dt = h0 + k0 + b0

T0

(6)

h0 + b0 + k0 T0 is the wealth of the household

Rt
R
h0 = 0 w (t )e 0 r (x )dx dt stands for the human capital
component of the wealth
b0 is the value of the public bonds at time t = 0

k0 is the stock of capital of the rms at time t = 0

Rt
R
T0 = 0 (t )e 0 r (x )dx dt is the present value of taxes
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1. Public debt
I

Using the intertemporal budget constraint of the government

(5):
Z
b0 =

[ (t )

g (t )] e

Rt
0

r (x )dx

dt

we can write the intertemporal budget constraint of the

household (6):
Z

c (t )e

Rt
0

r (x )dx

dt = h0 + k0 + b0

T0

as follows:
Z
0

c (t )e

Rt
0

r (x )dx

dt = h0 + k0

G0

(7)

which is identical to equation (2) with a0 = k0 .

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1. Public debt

Therefore, the budget constraint of the household is

independent of the level of public debt

The impact of public expenditures, fg (t ), t 0g on the

consumption of households and on the evolution of the stock
of capital is independent of the path of public debt
fb (t ), t 0g

I
I

The saving behavior of the household neutralizes the eect of

the public debt
Neutrality of public debt, Ricardo equivalence, Barro
equivalence

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1. Public debt

The neutrality of public debt relies on strong assumptions:

I
I
I
I

perfectly rational households

optimization over an innite time horizon
perfect credit market
non distortionary taxation

Actually, public debt is not neutral, but empirical studies nd

there is a negative correlation between public saving and
private saving2

2 see

for instance Luiz de Mello, Per Mathis Kongsrud and Robert Price,
2004, Saving Behaviour and the Eectiveness of Fiscal Policy , OCDE,
Economic Department paper, 397.
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2. Distortionary taxation

Until now, it has been assumed that taxes did not depend on:
1. capital income
2. labor income

Study of distortionary taxation on labor income:

I
I

the distortion is empirically important

can be studied with models that include labor supply

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2. Distortionary taxation

Measure of distortion: tax wedge

Let W and Pf respectively be the nominal wage received by

an employee and the producer price index.

tf the average rate of mandatory deductions from wages

borne by rms

The real labor cost for the employer is written:

wf =

W (1 + tf )
Pf

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2. Distortionary taxation
I

Denote by tc and te respectively the average rate of indirect

taxes on consumption and the average rate at which earned
income is taxed, net of benets received

Let Pc represent the consumer price index exclusive of

consumption taxes.

The purchasing power of an employee takes the form:

we =

W (1 te )
Pc (1 + tc )

Eliminating the nominal wage W between the expressions of

we and wf , we get:
wf = we

with

(1 + tc )(1 + tf )
( 1 te )

Pc
Pf

(8)

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2. Distortionary taxation

The term denes the wedge; it measures the ratio between

the cost of labor borne by the employer and the purchasing
power of wages.

The wedge has two components.

1. (Pc /Pf ), which is inuenced by the price of imports, because
Pc comprises import prices, whereas the producer price index
only comprises prices of domestic goods (which can however
be indirectly inuenced by import prices).
2. The tax wedge, which hinges on the tax rates tc , te and tf .

Henceforth, we will focus only on the tax wedge by setting the

ratio (Pc /Pf ) equal to one.

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2. Distortionary taxation

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

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2. Distortionary taxation

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

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2. Distortionary taxation

Direct taxes on earned income (income tax plus employeesand

employerscontributions), for a single person with no children paid at 100
percent of the average wage.
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2. Distortionary taxation

There are huge cross country dierences

Edward Prescott, 2004, Why Do Americans Work So Much

More than Europeans.", Federal Reserve Bank of Minneapolis,
issue July, pp. 2-13.

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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)
Eective marginal tax rate = (tc + te + tf )/(1 + tc ) () fraction of
labor income that is extracted in the form of taxes.
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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.
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2. Distortionary taxation

In order to show that dierences in hours worked across

countries may reect dierences in taxation, Prescott uses a
model of intertemporal labor supply

We present here a static version that highlights the main

thrust of the argument.

The static version corresponds to the steady state of the

neoclassical growth model

We shall rst remind the issue of tax incidence and then

analyze the impact of taxes on hours worked

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2. Distortionary taxation
I

Let us consider a competitive economy where the marginal

productivity of labor is FL (K , L), where L denotes the
quantity of labor

Firms pay a payroll tax denoted by Tf so that their marginal

prot per employee is equal to FL (K , L) w Tf where w
denotes the real gross wage.

At competitive equilibrium, prot maximization implies that

w = FL ( K , L ) Tf .

Workers pay taxes Te so that their net wage, we , is equal to

w Te .

Accordingly, the net wage is

we = F L ( K , L )

Tf

Te

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2. Distortionary taxation

In steady state, we have shown that FK (K , L) = r + , with

r = , which implies f 0 (k ) = + where k = K /L

Therefore we get
we = FL (k, 1)

Tf

Te

where k is determined by f 0 (k ) = + .

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2. Distortionary taxation
I

Equation
we = FL (k, 1)

Tf

Te

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
sc.
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
innitely elastic with respect to the wage.
In steady state with constant returns to scale, the marginal
productivity of labor is independent of the quantity of labor L
because rms adjust the stock of capital to keep the
capital/labor ratio k constant when the quantity of labor
changes.
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2. Distortionary taxation
I

It should be noted that empirical evaluations of the incidence

of taxes generally nd that changes in taxes have a strong
impact on net wages, which move in the direction opposite to
that of the taxes.

These ndings 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

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)

Henceforth, we will assume, without loss of generality, that

FL (k, 1) = 1 for the sake of simplicity.

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2. Distortionary taxation
I

The preferences of the representative individual are described

by the utility function:
U = log c + 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 > 0 species the value of leisure time for the
household

Each unit of labor produces one unit of good, which implies,

together with the zero prot condition, that the wage is equal
to 1, assuming that rms pay no tax.

Taxes on consumption and on labor earnings are assumed to

be proportional for the sake of simplicity.
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2. Distortionary taxation

The budget constraint of the consumer is

(1 + c )c = h (1

h ) + T

(9)

where c and 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.

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2. Distortionary taxation
I

Carrying this value into the utility function U and deriving

with respect to h, we nd that the optimal value of h veries:

(1 h )
h (1 h ) + T
I

1
1

= 0 ()

1 h
1 + c

1
1

This equation may also be written:

(1

) =

where
=

c
1

c + h
1 + c

(10)

(11)

is the eective marginal tax rate on labor income, which is the

fraction of labor income that is extracted in the form of taxes.
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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 = c c + h h .

Using the budget constraint (9) of the household, we nd that

c = h, i.e. that consumption equals labor income.

Substituting this equality into (10), we get the equilibrium

number of hours worked:
h=

1
.
+1

(12)

This equation shows that the duration of hours worked does

decrease with the eective marginal tax rate.

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2. Distortionary taxation

Prescott computes the average across-country value of and

sets the value of 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.

This allows him to argue that across-country variation in taxes

explains most of the dierences in hours worked.

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.

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2. Distortionary taxation

The literature distinguishes 3 types of labor supply elasticity

1. Marshall, or uncompensated
I
I

max U subject to the budget constraint

income and substitution eects

2. Hicks, or compensated
I
I

min expenditure subject to U

substitution eects only

3. Frisch
I
I

constant marginal utility of wealth

temporary changes in labor income

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2. Distortionary taxation

In the model of Prescott,

I
I

permanent changes in taxes

compensated by changes in transfers, implying that changes in
taxes have no income eects.

Hicksian elasticity of labor supply

Equation (12) allows us to compute the Hicksian elasticity of

labor supply with respect to net labor income (1 ), equal
to:
d log h

=
.
d log(1 )
+1

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2. Distortionary taxation

In the data of Prescott,

I
I
I

the average value of 1 amounts to 0.53.

equal to 1.54.
Accordingly, the Hicksian elasticity of labor supply predicted by
the model is about 0.74

This is only a little greater than usual estimated values of the

Hicksian elasticity which is about 0.5

Hence the model ts the data surprisingly well in this

dimension

Results on Frischian elasticity are less convincing (see tutorial)

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2. Distortionary taxation

What are the lessons of this exercise?

Prescott instructs us that dierences between countries in the

taxation of labor income can explain large dierences in hours
worked, for verisimilar values of the Hicksian elasticity of labor
supply.

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).

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2. Distortionary taxation

In practice, the impact of taxes on hours worked depends on

the bundle of features of each separate scal 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.

In light of this, it would be erroneous to conclude that a

country with a higher eective marginal tax rate on labor
income, measured as it is in Prescotts type of study that is,
as an average value has a tax system that is necessarily
more detrimental to the supply of hours worked.

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References
Blundell, R., Bozio, A. and Laroque, G., (2013), Extensive and intensive
margins of labour supply, Fiscal Studies, 34(1), pp. 1-29.
Chetty R., Guren, A., Manoli, D. and Weber, A. (2011), Are Micro and
Macro Labor Supply Elasticities Consistent? A Review of Evidence on the
Intensive and Extensive Margins, 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), An Exploration in the Theory of Optimum Income
Taxation, 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. 213.
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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