The Composition of Government Expenditure in an Overlapping Generations Model

This paper examines the choice of government expenditure on public goods and transfer payments (in the form of pension) under majority voting in an overlapping generations model, in which government expenditure is tax-?nanced on a pay-as-you-go (PAYG) basis. The condition required for majority support of the social contract involved in the PAYG scheme is established and shown to be independent of gov- ernment expenditure, so that the choice of expenditure composition can be made conditional on acceptance of this social contract. The model yields a closed-form solu-tion for the majority choice of the ratio of transfer payment to public goods, which depends negatively on the ratio of median to mean income, given parameters regarding preferences, tax, growth and interest rates. Informed by this result, a dataset for demo-cratic countries is examined, suggesting that income inequalities play a minor role in accounting for the substantial variations in the compostion of government expenditure across democratic countries, while di¤erent preferences for public goods resulting from cultural di¤erences may be an important determinant. Finally an alternative decision mechanism is also considered, in which a utilitarian government chooses expenditures to maximize a social welfare function. The solution is found to take a similar form to that of the majority voting context, except that a welfare-weighted average income replaces the median income.