Government Expenditure Financing in an Endogenous Growth Model: A Comparison

By Palivos, Theodore; Yip, Chong K. | Journal of Money, Credit & Banking, November 1995 | Go to article overview

Government Expenditure Financing in an Endogenous Growth Model: A Comparison


Palivos, Theodore, Yip, Chong K., Journal of Money, Credit & Banking


Recently there has been a renewed interest in issues of economic growth. The primary contribution of the new literature, pioneered by Romer (1986), Lucas (1988), and Rebelo (1991), has been to endogenize the growth rate of the economy and, in so doing, to promote our insights on the sorts of economic policies that can enhance the growth performance. One strand of the endogenous growth literature, in particular, examines the role of fiscal policy (especially taxation) in the growth process (see, for example, Barro 1990, King and Rebelo 1990, Alogoskoufis and Ploeg 1991, and Rebelo 1991) while another tries to identify mechanisms through which changes in monetary policy might influence economic growth (see Mino 1991, Ploeg and Alogoskoufis 1994, Jones and Manuelli 1993, and Wang and Yip 1993).

Drawing on both strands, this paper attempts to answer the following question. How should a government finance an expenditure path? Should it use fiscal (raise taxes) or monetary methods (issue money)? The answer to this question is crucial since any government considering existing or new spending programs must decide on how to raise the necessary revenue. It is well understood in the public finance/ macroeconomics literature that different government financing methods may have different effects on the aggregate economy (see, for example, Haliassos and Tobin 1990). Within the endogenous growth paradigm the issue becomes even more important since various economic policies have different impacts not only on the level of output but also on its growth rate.(1)

Turnovsky (1992) examines the impact of different methods of government expenditure financing in a Ramsey-Cass economy. Ploeg and Alogoskoufis (1994), on the other hand, develop an endogenous growth model with noninterconnected overlapping generations to examine the effects on growth and inflation of lump-sum-tax-financed, debt-financed, and money-financed increases in government consumption. Finally, Cooley and Hansen (1992) calibrate a real business cycle model and estimate the benefits of replacing a capital tax by other forms of taxation.

In this paper, we utilize a simple monetary endogenous growth framework to assess the relative merits of alternative modes of expenditure financing. We emphasize the transactional role of money via a generalized cash-in-advance or liquidity constraint. More specifically, we require that all consumption purchases but, different from Stockman (1981), only a fraction of investment purchases be made using cash. As long as that fraction is positive, money has real effects. In particular, an increase in the money growth rate will decrease the expansion rate of the economy.(2)

Following the differential tax incidence approach, we compare the growth and welfare effects of a permanent increase in government expenditure-income ratio under two alternative modes of financing: an increase in the income tax rate and an increase in the nominal money growth rate (seigniorage or inflation tax). The policy experiment we conduct is as follows. The government tries to maintain a continuously balanced budget or equivalently a constant share of government expenditure in GNP.(3) In particular, in each of the two financing policies the corresponding tax rate is endogenously determined to finance the given expenditure/income ratio, while the other tax rate is set to zero to facilitate comparison. Unlike Barro (1990), the services provided by the government are assumed not to enter households' utility or production functions. Although this affects the level of the growth rate and hence of welfare, it does not affect the relative ranking of alternative financing methods.

First, we derive some results regarding the growth and inflation rates under alternative financing schemes. Not only are these results interesting in their own right, but they are also used in the welfare analysis of different policies. We find, not surprisingly, that an increase in seigniorage or in the income tax rate decreases the growth rate of the economy. …

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