Economic Growth and Endogenous Fiscal Policy: In Search of a Data Consistent General Equilibrium Model

This paper searches for a general equilibrium model of optimal growth and endogenous fiscal policy with the aim of explaining the interaction between private agents and fiscal authorities in the U.S., West Germany, Japan and the U.K. over the period 1960-1996. Our search is conducted in the context of popular models with closed-form analytical solutions since this is necessary to formally test the models' theoretical restrictions. In West Germany and Japan there is evidence that the fiscal authorities act as optimizing Stackelberg leaders who are concerned about the current welfare of private agents. In contrast, the fiscal authorities in the U.S. and U.K. do not appear to act as optimizing agents; instead, they follow simple rule-of-thumb policy rules. In all countries, the tax smoothing model, according to which policymakers find it optimal not to react to the state of the economy, is rejected.