Fiscal Policy and Growth with Complementarities and Constraints on Government

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp11018.pdf Non-Technical SummaryGovernments are subject to a number of constraints that affect their ability to set fiscal policy optimally. This paper considers two. Firstly, governments are inevitably imperfectly informed about the production technology of firms and household preferences which both determine what level and what composition of public spending are optimal. Secondly, governments are constrained in their ability to change various elements of fiscal policy, due to, for example, quasi-fixed expenditure items such as social welfare benefits linked to entitlement conditions and interest payments that depend on the stock of public debt accumulated in the past. Other factors that constrain governments in this respect include limited administrative capacity (governments are only able to concentrate on a limited number of issues at a time) and limited political capital required for fiscal changes. We refer to this type of constraint as budget rigidities.In this paper we derive the optimal level and the optimal composition of public spending in the situation in which governments are constrained in their ability to alter both and know little about the relative growth benefits of different public spending categories. As a theoretical framework, we use endogenous growth models with public finance in which fiscal policy affects the long-run growth rate of the economy. Previous papers that have used this class of models typically ignore these constraints on governments, and assume that private and public inputs are substitutes.We generate a number of interesting results with respect to optimal fiscal policy in the presence of budget rigidities, informational limitations, or both in the realistic case when private and public inputs to private production that are provided by the government are complements. First, we show that the optimal level of productive public spending and the composition are interrelated: in particular, the optimal level of spending is higher when the composition is suboptimal, and the optimal share of public resources allocated to public investment may be very low when the level of spending is either too high or too low due to budget rigidities. This result contrasts with the common perception that public investment is the most important public spending category for long-run growth.Secondly, we show that imperfect knowledge of the government is much more...

Growth and Welfare Maximization in Models of Public Finance and Endogenous Growth

“…For the Cobb–Douglas technology case, Ghosh and Roy () show that the optimal tax rate and the optimal spending shares are interrelated (in the sense that the tax rate affects the optimal public spending composition and vice versa). Similarly, Misch, Gemmell, and Kneller () show that the optimal tax rate and the share of resources spent on public services are interrelated when public and private inputs to production are complements under growth maximization. These findings imply that in a model with public capital and public services, the relation between the growth‐ and welfare‐maximizing fiscal policies would become more complex…”

“…To illustrate, Misch et al . () demonstrate that in a second‐best situation where the shares of public spending on public services and of public investment are not set at their growth‐maximizing values, the growth‐maximizing level of taxation is higher compared to a first‐best situation. While the optimal tax rate and the optimal public spending composition are also interrelated under welfare maximization as shown by Ghosh and Roy (), it is unclear if second‐best interactions under welfare maximization are similar to the case of growth maximization.…”

Growth and Welfare Maximization in Models of Public Finance and Endogenous Growth

“…For the Cobb-Douglas tech- nology case, Ghosh and Roy (2004) show that the optimal tax rate and the optimal spending shares are interrelated (in the sense that the tax rate a¤ects the optimal public spending composition and vice versa). Similarly, Misch et al (2011) show that the optimal tax rate and the share of resources spent on public services are interrelated when public and private inputs to production are complements under growth maximization. These …ndings imply that in a model with public capital and public services, the relation between the growth-and welfare-maximizing …scal policies would become more still more complex.…”

“…18 The results of this paper, though derived from relatively abstract models, have important policy implications. The knowledge available to governments 18 To illustrate, Misch et al (2011) demonstrate that in a second-best situation where the shares of public spending on public services and of public investment are not set at their growth-maximizing values, the growth-maximizing level of taxation is higher compared to a …rst-best situation. While the optimal tax rate and the optimal public spending composition are also interrelated under welfare maximization as shown by Ghosh and Roy (2004), it is unclear if second-best interactions under welfare maximization are similar to the case of growth maximization.…”