The Effect of Fiscal Policy

Fiscal policy cannot affect the long-run growth rate, n. However, it may affect long- run capital intensity, k*. As shown in Fig. 5.4, an increase in t moves the s(1 — t)f (k) curve downward; hence, the long-run equilibrium point moves from E0 to E1. Thus, long-run capital intensity declines; namely, an increase in the tax rate depresses capital accumulation. During the transition from E0 to E1, K declines more than L, which means that the growth rate of capital is less than the growth rate of labor, n, during the transition. In this sense, an increase in the tax rate reduces the growth rate during the transition.

So far, we have assumed that tax revenue is used for government consumption. Now, as in Sect. 1, let us introduce public investment. First, we assume that all government spending is used for public investment, X = 1and 0 = 1. Then, under the balanced budget rule, we have

Further, Eq. (5.19) may be rewritten as

In this regard, an increase in t moves the [s +1(1 — s)]f(k) curve upward. Hence, an increase in government spending enhances capital intensity and capital accumulation. Generally, if we consider the case of X < 1, then we have to compare X and s. If X > s, an increase in government spending stimulates capital accumulation as in Sect. 1, and vice versa.

When capital accumulation is extended in the long run, K grows at a greater rate than n during the transition. Thus, the growth rate of GDP, ю, is also greater than n during the transition. In other words, such fiscal policy also stimulates economic growth ю during the transition, although the long-run growth rate is given by the population growth rate, n. If it is plausible to assume X < s, an increase in the tax rate depresses capital accumulation. Further, even if X > s, the productivity of public investment may be smaller than the productivity of private investment, with low productivity of public capital compared with private capital, 0. If so, the sign of 0X — s becomes negative; hence, we still have a negative relationship between tax and capital accumulation.

 
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