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

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.