The Economic Effects of Financing a Large and Permanent Increase in Government Spending

In this working paper, we analyze the long-term economic effects of financing a large and permanent increase in government expenditures of 5 percent to 10 percent of gross domestic product (GDP) annually. This paper does not assess the economic effects of the increased government spending and focuses solely on the effects of their financing.

The first part of the paper reviews the channels through which different financing mechanisms affect the economy. Specifically, the review focuses on how taxes on labor income, capital income, and consumption affect how much people work and save. The general finding is that increasing taxes leads to lower GDP and personal consumption. Finally, deficit financing leads to higher interest rates, a lower capital stock, lower GDP, and a greater risk of a fiscal crisis