Three Essays on the Political Economy of Fiscal Policy

This study focuses on different aspects of fiscal policy. The second and third chapters investigate drivers of fiscal policy whereas the fourth chapter investigates its consequences. The second chapter analyses how changes in demographic structure affects policy variables. Building on Razin, Sadka and Swagel (2002) we propose a U-shape relationship between labor income tax rates and the share of retirees. Using data from 1991-2012 for 13 OECD countries, the results related to income taxes and the size of government are found to reconcile with theory after controlling for possible endogeneity and presence of unit roots. Borrowing from Meltzer and Richard (1981) the impact of a rise in inequality on tax composition is examined in the third chapter. Based on median voter model we propose that direct (income) taxes monotonically increase with inequality, whilst indirect (expenditure) taxes exhibit a U-shaped relationship with inequality. Moreover, based on voters’ myopia, how changes in inequality affect deficits and debt is also examined. Using cross-country data for 129 countries the empirical results are found to be consistent with theory and especially in strong democracies. With panel data estimates, the findings also partially support our theory. The fourth chapter examines the Armey (1995) curve assessing the relationship between economic growth and the government size. We find strong evidence for presence of the Armey curve across non-OECD countries. Government expenditures are found to be optimized in terms of economic growth at 23.99% of GDP. Employing panel data estimation we use a recent data set for 79 countries from 1981-2010, taking five years averages. The results also hold for weak democracies whereas the OECDs and strongly democracies are found to sustain larger governments as findings related to them are mixed. Empirical analysis is also extended decomposing public expenditures, taking direct transfers and GDP per capita as policy variables.