Utility and productivity enhancing public capital in a growing economy

Abstract

We examine the impact of fiscal policy on macroeconomic performance and welfare when public capital provides both productive and utility services to the private sector. When these services are subject to congestion, a consumption tax is distortionary, generating a dynamic adjustment that contrasts with that of an income tax. In correcting for congestion, an income tax-consumption sub-sidy combination is the preferred policy when factor-substitutability in production is limited. On the other hand, an increase in the elasticity of substitution in production raises the e¢ cacy of a consumption tax as an alternative to the income tax. Not recognizing the relative importance of public capital in utility services might lead the fiscal authority to incorrectly estimate the impact of public policies on welfare. The design of optimal scal policy demonstrates the possibilities for using both income and consumption-based fiscal instruments as opposed to relying on only the income tax rate.