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September 21, 2020, Christopher D. Carroll RCKWithGov

The Ramsey/Cass-Koopmans (RCK) Model with Government

http://www.econ2.jhu.edu/people/ccarroll/public/lecturenotes

This handout solves the Ramsey/Cass-Koopmans (RCK) model with government.1

For simplicity we assume no technological progress, population growth, or depreciation,
and a continuum of consumers with mass 1 distributed on the unit interval as per
Aggregation.
Consider first the case where government is financed by constant lump-sum taxes of
amount τ per period, and spending is at rate x per period, and suppose the government
has a balanced budget requirement so that x = τ in every period and there is no
government debt. We suppose further that government spending yields no utility. The
individual’s optimization problem (leaving out the i subscripts that we used in the
previous handout, but understanding that they are implicitly present) is now
Z ∞
u(ct )e−ϑt (1)
0
subject to the household DBC
ȧt = rt at + wt − ct − τ, (2)
which has Hamiltonian representation
H(at , ct , λt ) = u(ct ) + (rt at + wt − ct − τ )λt
The first Hamiltonian optimization condition requires ∂Ht /∂ct = 0:
c−ρ
t = λt
(3)
−ρc−ρ−1
t ċt = λ̇t
The second Hamiltonian optimization condition requires:
λ̇t = ϑλt − (∂Ht /∂at )λt
= ϑλt − λt rt
(4)
λ̇t /λt = (ϑ − rt )
ċt /ct = ρ−1 (rt − ϑ).
Finally, the household’s behavior must satisfy a transversality constraint, which is
equivalent to the intertemporal budget constraint:
Z ∞ Z ∞ Z ∞
−1 −1
ct Rt = a0 + yt Rt − τ R−1
t
0 0 0 (5)
C 0 = a0 + Y 0 − T 0
which says that the present discounted value of consumption must equal the current net
physical wealth plus human wealth minus the PDV of taxes.

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The treatment is similar to that in Blanchard and Fischer (1989); see that source for more details.
 Now consider the problem from the standpoint of a social planner who has the same
utility function as the individual consumers. If the social planner wants to spend a
constant amount x per period, the social planner’s budget constraint is
k̇t = f(kt ) − δkt − ct − x (6)
which reflects the fact that the social planner divides total net output between consump-
tion and government spending. This leads to Hamiltonian
H(kt , ct , λt ) = u(ct ) + λt (f(kt ) − δkt − ct − x), (7)
yielding the first order condition
ċt /ct = ρ−1 (f(kt ) − δ − ϑ). (8)
Now recall from the handout on decentralizing the RCK model that
f(kt ) = r̂t kt + wt (9)
where the gross return on capital r̂t is equal to the net return rt plus the depreciation
rate.
Thus, the social planner’s DBC is:
k̇t = f(kt ) − δkt − ct − x
= r̂t kt − δkt + wt − ct − x (10)
= rt kt + wt − ct − x,
which is equivalent to the household’s budget constraint (2) when at = kt and τ = x.
As discussed in DecentralizingRCK, at = kt must hold in equilibrium for identical
households, and τ = x was the balanced budget assumption that we started off with.
Note that the ċt = 0 locus in the phase diagram is unchanged by changing τ and x.
However, the k̇t = 0 locus is shifted down by amount τ = x.
Now what happens if the government does not face a balanced budget requirement?
Specifically, suppose we continue to have the same constant amount of spending per
period but now want to consider the effect of allowing taxes to vary over time, which
we denote by a subscript on τt . Suppose d is the level of government bonds (debt); the
government’s Dynamic Budget Constraint is
d˙t = x + rt dt − τt , (11)
which says that debt must rise by the amount by which spending exceeds taxes.
The government’s IBC will be the integral of its DBC:
Z ∞ Z ∞
−1
d0 + xRt = τ R−1
t
0 0 (12)
d0 + X 0 = T0
and we assume d0 = 0 so that the government starts out with no debt (to maintain
comparability with the previous example).
The DBC of the idiosyncratic family also changes. They can now own either capital
kt or government debt dt . If the family is to be indifferent between the two forms of

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assets, the interest rate must be the same.
ct + ȧt = wt + rt at − τt
(13)
at = k t + d t .
Now the family’s IBC becomes
Z ∞ Z ∞
−1
ct Rt = k0 + d0 + Y0 − τt R−1
t
0 0 (14)
= k0 + d0 + Y0 − T0 .
Note: Nowhere in this equation does the time path of taxes matter; all that matters
is the PDV of taxes. And the time path of taxes also does not enter the ċ/c equation.
Thus, the path of consumption over time is unaffected by the path of taxes over time!
This is not so surprising when you realize that it is simply the Ricardian equivalence
proposition in this perfect foresight framework.
However, now consider the case where there is a tax on capital income at rate τ .
Furthermore, for simplicity suppose that the government rebates all of the tax revenue
in a lump sum per capita, and suppose depreciation δ = 0. Thus the household budget
constraint becomes
ȧt = rt (1 − τ )at + wt − ct + zt (15)
where zt is the per-capita size of the lump-sum rebates,
zt = τ rt kt . (16)
The household’s Hamiltonian becomes
Ht (ct , at , λt ) = u(ct ) + λt (rt (1 − τ )at + wt − ct + zt ). (17)
The crucial difference between this situation and the previous one is that now the
effective rate of return on saving has been decreased, so that ∂Ht /∂at is now rt (1 − τ )
rather than rt . Ultimately this produces a consumption Euler equation of
ċt /ct = ρ−1 ((1 − τ )rt − ϑ) (18)
which implies that the economy will be in equilibrium at
f(k̄)(1 − τ ) = ϑ
(19)
f(k̄) = ϑ
so that the equilibrium level of the marginal product of capital is higher, and the capital
stock must therefore be lower, than before the capital taxation was instituted.
Notice, however, that because the taxes are being rebated, the aggregate budget
constraint does not change when the tax is imposed:
k̇t = rt (1 − τ )kt + wt − ct + τ kt rt
(20)
= rt kt + wt − ct .
Thus the social planner will choose exactly the same amount of consumption as before
the tax was instituted.

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 The crucial point is that if an individual household saves more and thus causes next
year’s capital stock to be a bit higher, the personal benefit to that household is essentially
zero. The higher taxes that the household will pay next year will be distributed to the
entire population in a lump sum, so the saver will get nothing. The higher saving of
this individual household is basically a positive externality from the point of view of the
other consumers in the economy. However, if the social planner forces the economy as a
whole to save more, the social planner receives all of the extra tax revenue.

References
Blanchard, Olivier, and Stanley Fischer (1989): Lectures on Macroeconomics.
MIT Press.