A Lost Decade of Fiscal Misallocation

This paper examines how fiscal windfalls from interest rate cuts influenced resource allocation during Japan’s Lost Decade (1993-2002). We document two key empirical patterns: a shift of resources from private to government sectors and a deteriorating spatial allocation of government investments. We develop a politico-economic theory where fiscal windfalls induce allocation to be more politically driven than efficiency-oriented. This theoretical mechanism is incorporated into a quantitative model calibrated to the Japanese economy. We conduct counterfactuals to assess the quantitative effects of fiscal windfalls. If the government transfers these windfalls to households while maintaining the same debt trajectory, we find lower government consumption and investment levels, as well as a much improved spatial allocation of government capital, which would have increased aggregate TFP by 0.53% and welfare by nearly 1% during the Lost Decade.