A Dynamic Theory of Public Spending, Taxation, and Debt

This paper presents a dynamic political economy theory of public spending, taxation, and debt. The theory builds on the well-known tax smoothing approach to fiscal policy pioneered by Robert Barro (1979). This approach predicts that governments will use budget surpluses and deficits as a buffer to prevent tax rates from changing too sharply. Thus, governments will run deficits in times of high government spending needs and surpluses when needs are low. Underlying the approach are the assumptions that governments are benevolent, that government spending needs fluctuate over time, and that the deadweight costs of income taxes are a convex function of the tax rate. The economic environment underlying our theory is similar to that in the tax smoothing literature. Our key departure is that policy decisions are made by a legislature rather than a benevolent planner. Moreover, we introduce the friction that legislators can distribute revenues back to their districts via pork-barrel spending. More specifically, our theory assumes that policy choices are made by a legislature comprised of representatives elected by single-member, geographically defined districts. The legislature can raise revenues in two ways: via a proportional tax on labor income and by borrowing in the capital market. Borrowing takes the form of issuing risk-free one-period bonds. The legislature can also purchase bonds and use the interest earnings to help finance future public spending if it so chooses. Public revenues are used to finance the provision of a public good that benefits all citizens and to provide targeted district-specific transfers, which are interpreted as pork-barrel spending. The value of the public good to citizens is stochastic, reflecting shocks such as wars or natural disasters. The legislature makes policy decisions by majority (or super-majority) rule and legislative policymaking in each period is modelled using the legislative bargaining approach of David Baron and John Ferejohn (1989). The level of public debt acts as a state variable, creating a dynamic linkage across policymaking periods. A Dynamic Theory of Public Spending, Taxation, and Debt