The Transitional Dynamics of Fiscal Policy: Long-Run Capital Accumulation and Growth

Abstract

Recent research in growth theory has established the importance of the non-scale growth model, a key advantage of which is that they are consistent with balanced growth under quite general production structures. Indeed, if the knife-edge restriction that generates traditional endogenous growth models is not imposed, then any stable balanced growth equilibrium is characterized by the absence of scale effects. In this case the long-run equilibrium growth rate is determined by technological parameters and is independent of macro policy instruments.Despite the fact that the equilibrium growth rate is independent of macro policy, fiscal policy remains an important determinant of long-run economic performance. First, fiscal policy has significant effects on the levels of key economic variables, such as the per capita stock of capital and output. Moreover, the non-scale model typically yields slow asymptotic speeds of convergence, consistent with the empirical evidence of 2-3% per annum. This implies that policy changes can affect growth rates for sustained periods of time, so that the accumulated effects of policy changes during the transition from one equilibrium to another may therefore translate to potentially large impacts on steady-state levels. Thus, although the stock of capital grows at the same rates across steady states, the corresponding bases upon which the growth rates compound may be substantially different.These considerations suggest that attention should be directed to determining the impact of fiscal policy on the transitional dynamics. This is the focus of the present paper. The model we employ is of a one-sector economy in which output depends upon the stocks of both private and public capital, as well as endogenously supplied labor. Public capital introduces a positive externality in production, so that the complete production function is one of overall increasing returns to scale in these three productive factors. In addition to accumulating public capital, the government allocates resources to a utility-enhancing consumption good. These expenditures are financed by taxing capital, labor income, and consumption, or by imposing non-distortionary lump-sum taxation. We set out the dynamic equilibrium of this economy and show how the stable adjustment is characterized by a two dimensional locus in terms of the two stationary variables, referred to as "scale-adjusted" per capita stocks of private and public capital.Our analysis focuses on two aspects. First, we characterize the steady state equilibrium and analyze the effects of various fiscal changes on the long-run labor-leisure allocation, the long-run changes in the capital stocks, and output. We compare the long-run effects of the two forms of government expenditure ? investment versus consumption ? and changes in the alternative tax rates. Distortionary tax-financed increases in both forms of government expenditure are analyzed and shown to be amalgams of these effects. Most of our attention is devoted to calibrating the model to a benchmark economy and assessing the numerical effects of various types of policy shocks, relative to the benchmark. We consider both the long-run equilibrium response and the transitional adjustment paths. Particular attention is devoted to the welfare of the representative agent, both the time profile of instantaneous utility and the intertemporal welfare, as represented by the discounted sum of the short-run benefits. The implications for the government?s intertemporal budget balance are also addressed. Our numerical analysis yields many insights into the transitional dynamics, and the following are noted. 1. Despite the fact that fiscal policy in such an economy has no effect on the long-run equilibrium growth rate, the slow rate of convergence implies that fiscal policy exerts has a sustained impact on growth rates for substantial periods during the transition. These accumulate to substantial effects on the long-run equilibrium levels of crucial economic variables, including welfare.2. As examples of the accumulated impacts of policy, an increase in government investment from 0.08 to 0.14 of output raises the long level of output by 40%. Raising the tax on capital income from 0.28 to 0.40 reduces long-run output by 16%.3. For the calibrated economy allocating a fixed fraction of output to government investment is better than allocating the same resources to government consumption. However, the intertemporal time profiles of the respective benefits are different. The benefits of (lump-sum tax-financed) government consumption are uniformly positive; government investment involves short-run losses, which are more than more than offset over time. These comparisons depend upon the sizes of the two government expenditures, relative to their respective first-best optimal values and could be reversed in other situations.4. The time paths and growth rates of private and public capital contrast sharply for policies which impact on one or other directly; they move closely for those fiscal shocks which do not impact directly on either form of capital. The most dramatic contrasts in the time paths for the two types of capital occur with respect to an increase in government consumption expenditure, under the four alternative modes of tax financing. Long-run stocks of both increase proportionately under lump-sum taxes; remain unchanged under consumption tax-financing, decrease proportionately under wage tax-financing, and lead to a more than proportional decline in private capital under capital tax-financing.5. Our numerical simulations suggest the following ranking for the different modes of financing. For either form of expenditure, lump-sum tax financing dominates consumption tax financing, which in turn dominates wage tax financing and finally capital tax financing, in terms of long-run welfare. These rankings are reflected in the long-run output multipliers.6. The fact that wage tax-financing dominates capital tax-financing, despite the fact that a given increase in the former has a more adverse effect than does a comparable increase in the latter is of interest. It reflects the fact that being levied on a larger base, a smaller rise in the wage tax is required to generate the required revenue to finance the higher expenditure.7. The analysis highlights the intertemporal welfare tradeoffs involved in policy changes. For example, both the substitution of a consumption tax for a uniform reduction in the income tax and a revenue-neutral switch from government consumption to government investment lead to a short-run welfare losses, which in both cases are more than offset by long-run welfare gains. This is a consequence of the growth generated during the subsequent transition.

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