The Heterogeneous Effects of Government Spending: It's All About Taxes

Abstract

Empirical work suggests that while government spending induces an increase in output, it does not signi ficantly decrease private consumption. Contrary to these fi ndings, most representative-household models in macroeconomics predict a crowding-out of private consumption by government spending. To address this issue, we develop a model with heterogeneous households and uninsurable idiosyncratic risk as in Aiyagari (1994). In a model with heterogeneous households, progressivity of taxes is a key determinant of the eff ects of government spending. A rise in government spending can be expansionary, both for output and consumption, if financed with more progressive labor taxes. However, it is contractionary if financed with less progressive taxes. With a narrative approach, we use large changes in military spending to provide evidence that government spending in the United States has been expansionary only in periods of increasing progressivity.