Michael Dotsey and Ching-Sheng Mao
This paper studies the effects of fiscal policies--depicted as stochastic changes in government spending and distortionary tax rates--when the government cannot use lump sum taxes to achieve intertemporal budget balance. This framework contrasts the more standard analysis in which spending and taxes follow exogenous Markov process and where lump sum taxation is used to balance the government's budget. Although we also model tax rates and spending as following Markov processes, the transition probabilities of these processes depend on the ration of government debt to gnp. The ratio of debt to gnp, will have consequences for the future choices of government spending and distortionary taxation and hence will affect real economic activity. The paper, therefore, is able to contribute to current public discussions over the economic effects of debt and deficits and to the effects of policies that attempt to reduce the deficit through cuts in government expenditures or increases in distortionary taxation.