Endogenous growth with public capital and progressive taxation

It has been widely acknowledged that changes in fiscal policy have an impact on both growth and the income distribution. However, the theoretical models used to study the effects of various fiscal policy reforms have either focused on the change in the economy's long-run growth rate ignoring the distributional aspects of the policy change, or focused on the change in the income distribution ignoring the effect on the growth rate. This paper considers a tractable endogenous growth model with public capital and heterogeneous agents who are subjected to progressive income taxes. The model allows us to study the interaction between the growth effects and the distributional effects resulting from a change in fiscal policy. As a result, it offers a more complete assessment of the overall effect of a fiscal policy reform relative to the previous literature which determined the growth effects independently of the distributional effects and vice versa.

Government expenditures, including public investment, are financed through a progressive income taxation scheme along with a flat tax on consumption. The model is calibrated to the postwar U.S. economy. Three major fiscal policy reforms are considered: (i) an increase in the degree of progressivity of the tax schedule, (ii) the adoption of a flat income tax rate, and (iii) an increase in the fraction of output allocated to public investment. The effects of each of these reforms on the economy's growth rate and income distribution are analyzed. It is shown that along the balanced growth path increasing investment in public capital is the only type of policy that simultaneously enhances growth and reduces income inequality.