Growth and welfare: Distorting versus non-distorting taxes

Including a wasteful component of public expenditures in an endogenous growth framework similar to Barro [Journal of Political Economy 98 (5) (1990) S103-S125], we analytically characterize optimal public investment under two alternative tax systems. Since households do not internalize the fact that higher capital accumulation will lead to extra public investment and consumption, financing public expenditures through lump-sum taxes will lead to an excessive crowding-out of current consumption, reducing consumption in the short-run and limiting public capital accumulation and long-run growth. This effect can be more damaging for welfare than the disincentive created on private capital accumulation when taxing capital income.