Public Debt, Redistribution, and Growth

We study the implications of economic growth for the generosity and the financing of the welfare state. In a simple model without savings, we first derive some benchmark conditions under which both the generosity of the welfare state and tax progressivity are independent of the level of economic development. This homothetic benchmark extends to the case of external public debt if the interest rate equals a threshold which depends not only on preference parameters, but also on the growth rate. When growth rates are high and interest rates are be- low this threshold, governments of growing economies should issue public debt to finance a generous welfare state initially; tax progressivity will then increase eventually to finance the service of the debt. We show that this force is quantitatively large. Finally, homotheticity also extends to internal savings between the government and the private agents, as long as there is no initial wealth inequality across agents: the optimal welfare state and tax progressivity are constant and the endogenous interest rate is such that there is no savings. Next, we break homotheticity by introducing subsistence levels. We analytically show that in autarky, positive subsistence levels imply a more generous welfare state at earlier stages of development, financed with more progressive taxes. When allowing for external borrowing, even at the interest rate threshold for which there is no motive for borrowing in the homothetic benchmark, subsistence levels translate into interesting dynamics. The welfare state should be more generous initially, but this should solely be financed with public debt. The standard tax smoothing result remains. With internal debt, the government should use public debt to finance an initially more generous welfare state. However, optimal tax progressivity initially increases. The increase in tax progressivity is desirable because it improves the terms of trade for the government. Finally, we study the effects of initial asset inequality. Preliminary analytical results suggest that wealth inequality generate a force for increasing tax progres- sivity to improve the terms of trade for the poor households. The magnitude of this price manipulation mechanism depends on initial and future growth.