Social polarization, "scal instability and growth

We present a dynamic model of "scal policy in a simple growth framework where social polarization (of preferences) plays a central role in the evolution of "scal instability and growth collapse. In a highly polarized society, a de"cit occurs endogenously, "scal spending path becomes more volatile, output collapses, and economic growth rate is reduced along the transition path to a new lower level of output. One novel feature is that the size of "scal de"cit, the magnitude of "scal volatility, and the size of reduction in output and growth rate are explicitly shown to be increasing functions of the degree of social polarization. This is because of the positive relationship between the polarization of preferences and the incentive for policymakers (or socio-economic groups) to overexploit the government resources in a common pool setting (polarization e2ect). Thereby, we o2er a "scal instability channel that negatively links social polarization and growth, which is an alternative yet distinct explanation for the empirical "nding that social polarization is harmful to growth. Moreover, we fully distinguish the incentive to engage in such short-term policies under political uncertainty from that under polarization. Polarization and political uncertainty are shown to be distinct yet critical to the dynamic coordination failure in the common pool setting. c © 2004 Elsevier B.V. All rights reserved. JEL classi'cation: E62; H60; H30; O40