Optimal time-consistent fiscal policy under endogenous growth with elastic labour supply

Alfonso Novales, Rafaela Perez and Jesus Ruiz

No 2013-24, Documentos de Trabajo del ICAE from Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico

Abstract: In an endogenous growth model with public consumption and investment and an elastic labour supply, we explore the time-consistent optimal choice for two policy instruments: an income tax rate and the split of government spending between consumption and investment. We compare the Markovian optimal policy with the Ramsey policy, extending previous works that characterized optimal fiscal policy either in an exogenous growth framework, assuming an exogenously given split of income between consumption and investment, or an inelastic supply of labour. The Markov-perfect policy implies a higher income tax rate. To compensate for the lower disposable income, a larger proportion of government spending is allocated to consumption than those chosen under a commitment constraint on the part of the government. As a result, economic growth is slightly lower under the Markov-perfect policy than under the Ramsey policy. The welfare loss relative to the benevolent planner’s solution is mainly due to the difference in growth rates.

Keywords: Time-consistency; Markov-perfect optimal policy; Ramsey optimal policy; Endogenous growth; Income tax rate; Government spending composition. Note: The authors thank financial support received from the Spanish Ministry of Science and Innovation through grant ECO2012-31941, the Research Groups funding program by Universidad Complutense de Madrid and Banco Santander, the Xunta de Galicia through Grant 10PXIB300177PR and the Research Grant program in Economics at Fundación Ramón Areces. (search for similar items in EconPapers)
JEL-codes: E61 E62 H21 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2013-06
New Economics Papers: this item is included in nep-dge, nep-mac and nep-pbe
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Journal Article: Optimal time-consistent fiscal policy under endogenous growth with elastic labor supply (2014)
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