Cross-country differences in the size and composition of the government budget have stimulated a lively debate on the effect of fiscal policy. Quite a large body of evidence has accumulated on the influence of fiscal policy instruments on the macroeconomy while less is known about the distributional effects of changes in the government budget's composition. Theoretically, macroeconomists have limited their analysis to the impact of a limited set of fiscal policy variables in economies with perfectly competitive labor markets. However, in several OECD countries (mainly continental Europe) unions are very powerful and their presence can influence the effects and the transmission mechanism of fiscal shocks.
With the exception of Ardagna (2001), Cavallo (2003), Finn (1998), and Pappa (2004), macro-economists have focused on the effect of government purchases of consumption and capital goods and of different types of tax rates. They have mostly overlooked the effects of changes in welfare spend-ing and public employment even if these items account for almost three quarters of total government spending in OECD countries and since 1960 have become a larger share of total government spend-ing. Finally, theory has largely ignored distributional issues. In fact, the general equilibrium effects of changes in fiscal policy have mostly been addressed in models witha representative agent.
These considerations suggest possible extensions to the existing literature and motivate the present paper. Specifically, the goal of this paper is to extend the work of Ardagna (2001), Cavallo (2003), Finn (1998), and Pappa (2004) to an economy with unionized labor markets and heterogeneous agents and examine the macroeconomic and distributional consequences of changes in a wide set of fiscal instruments.
To do so, the paper introduces fiscal policy into the monopoly union model of Maffezzoli (2001). In particular, the paper focuses on a two sector economy in which private firms produce a homogeneous consumption good using both capital and labor and the government hires public employees to provide public services. The labor market is unionized and heterogenous agents (capitalists, private and public sector employees, and unemployed workers) populate the economy.
