The macroeconomic effects of government debt in a stochastic growth model

This paper studies how government liabilities affect macroeconomic aggregates in a standard general equilibrium growth model. There are two principal results: (i) Though it is often thought that fiscal deficits crowd out investment, this paper shows that deficit-financed cuts in distortionary income taxation may stimulate investment even if agents expect future taxes on capital income to be higher. This result is dependent on the values of two key parameters: the elasticity of labor supply and the degree of persistence in the government debt process. (ii) The economy's response to an increase in government expenditure depends on how it is financed. Distortionary tax finance may lead to a decline in output, consumption, and investment. In contrast, deficit finance may increase output and consumption.