FISCAL POLICY, EXPECTATION TRAPS, AND CHILD LABOR

I. INTRODUCTION Child labor is widespread in the contemporary world. In fact, the International Labor Organization (ILO) estimates that 246 million of the world's children aged 5-17, or 16%, are child laborers, most living in developing countries. (1) Recently, there has been renewed interest in this topic among economists, which has led to a series of theoretical studies with the aim of better understanding the causes and consequences of child labor in order to help guide appropriate policy responses, as in Grootaert and Kanbur (1995), Basu (1999), and Basu and Tzannatos (2003 for useful literature surveys). Typically, theoretical models designed to address the important policy issues surrounding child labor posit that a family's decision to send a child to the labor market is taken only as a last resort in order to escape the dire consequences of poverty, for example, Basu and Van (1998). Baland and Robinson (2000) show that this response on the part of the family may be stronger in a dynamic setting because contracts between children and adults are not self-enforcing, and capital markets are incomplete. (2) In this case, an adult decision-maker may not only send their children to work to escape poverty in the present, but do so to escape poverty in the future as well. This decision will hinder a child's ability to accumulate human capital and can lead to persistent cycles of poverty and child labor across generations. (3) We begin by showing that a benevolent government can address the incidence of child labor that results from the non-enforceability of intergenerational contracts and incomplete capital markets through the appropriate use of fiscal policy and that this policy is Pareto improving. It is then shown that if society's confidence in their government is incomplete, this lack of confidence can render the same fiscal policy ineffective. In other words, if households do not believe that the government will follow through on their policy promise, then in fact, it is quite possible that the government will not be able to follow through on their promise as a result of these beliefs. (4) This self-reinforcing nature of fiscal policy in the presence of uncertainty can leave a country in an expectations trap with a low level of human capital and child labor. (5) To formally demonstrate this fiscal policy expectations trap hypothesis, we employ a three-period overlapping generations model in which child labor exists. (6) This stylized setup will keep the dynamics manageable and allow us to highlight the effects of uncertainty. Also, within this framework we introduce a missing intergenerational contracts market, in conjunction with a human-capital production function that exhibits a threshold with respect to parental human capital, which gives rise to two locally stable steady states. There is a "good" equilibrium where there is a relatively high level of parental human capital, which results in a high level of income and no child labor, and there is a "bad" equilibrium where there is a relatively low level of parental human capital, which results in a low level of income and positive child labor. This low income-child labor equilibrium is the standard poverty trap scenario that typically exists in a deterministic economy with multiple equilibria. It is then shown that a benevolent government can replicate the missing intergenerational contracts market with a pay-as-you-go social security program, thereby eliminating this component of child labor in an economy with perfect foresight. In addition, it is also shown that this policy is Pareto improving in the sense that all generations are strictly better off under this policy, except the initial old who are no worse off. The dynamics of this social security program are intuitive: If child labor is one possible mechanism adults can use to redistribute resources from their children, then the government can reduce this incentive by announcing a social security program that will begin during the current adults' old age (an institutional intergenerational contract). …