Long-run growth and welfare effects of public policies with distortionary taxation

In a one-sector growth model with infrastructure investment, we study the impact of fiscal policies on growth. The government collects taxes on labor income and profits. The government uses these revenues to purchase infrastructure investment, provide utility enhancing government services, and to provide transfer payments to the households. We show that the balanced growth rate is an increasing function of the percent of government revenues that goes to infrastructure. We find that the growth maximizing mix of taxes depends on the elasticity of substitution between inputs. In particular, with distortionary taxes, the growth maximizing tax rate on capital is higher the lower the elasticity of substitution between private physical capital and public capital. In addition, the growth maximizing size of the government is higher when the elasticity of substitution between public and private inputs is low. We also investigate welfare effects of other public expenditures as well. Depending on the elasticity of substitution in production, the welfare implications of different public policies can be substantial.