DEBT POLICY RULE, PRODUCTIVE GOVERNMENT SPENDING, AND MULTIPLE GROWTH PATHS

Abstract

This paper constructs an endogenous growth model with productive government spending. In this model, the government can finance its costs through income tax and government debt and has a target level of government debt relative to the size of the economy. We show that there are two steady states. One is associated with high growth and the other with low growth. It is also shown that whether the government uses income taxes or government bonds makes the results differ significantly. In particular, an increase in government bonds reduces the growth rate in the high-growth steady state and raises the growth rate in the low-growth steady state. Conversely, an increase in the income tax rate reduces the growth rate in the low-growth steady state and there exists some tax rate that maximizes the growth rate in the high-growth steady state. Finally, the level of welfare in the low-growth steady state is lower than that in the high-growth steady state.

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