Growth and Welfare Maximization in Models of Public Finance and Endogenous Growth

The comparison between growth‐maximizing and welfare‐maximizing fiscal policy over the long run is a central issue in models of public finance and endogenous growth. It is also important from a policymaking perspective: although the maximization of welfare is typically characterized as the primary objective of benevolent governments, imperfect knowledge about the preferences of households make it difficult to pursue a first‐best strategy to achieve this. An obvious second‐best strategy, because changes in income are easier to measure than welfare, is a policy of growth maximization. As a further complication, policy makers often perceive a distinction between the provision of social public services necessary to meet objectives related to social welfare and those expenditures necessary to achieve higher growth rates. Discussions of this nature feature frequently in policy debates. This paper uses models of public finance and growth to evaluate the extent of the trade‐off between growth and welfare maximization in the absence of redistributive issues, and therefore the policy conclusions with respect to the optimal tax rate and the optimal level of public spending that can be drawn, from two perspectives. The first compares the welfare‐maximizing and growth‐maximizing tax rates found under different assumptions in models of public finance and growth. In so doing we synthesize as well as extend the theoretical literature. A key outcome of this exercise is to highlight the range of conclusions that can be drawn from this class of theoretical models. The growth‐maximizing tax rate can be the same as, higher, or lower than the welfare‐maximizing equivalent, as a result of small changes in model assumptions about the nature of the effects of fiscal policy and the technology of private production. The second perspective on the question of the trade‐off between growth and welfare maximization considers the extent to which growth and welfare maximization yield distinct outcomes in terms of the growth rates and welfare levels along the balanced growth path. This is a question that is often ignored in the literature, even though ultimately, differences in outcomes represent the main trade‐off of interest arising from growth versus welfare maximization objectives. The results from this exercise are striking and serve to modify the policy conclusions that might be drawn from the first part of the paper. Even when the differences between the tax rate necessary to maximize growth compared to the tax rate under welfare maximization are relatively large, we find that this translates into differences in growth rates that are relatively small, and in some cases, they also translate into relatively small differences in welfare levels. We establish that this holds for a large array of possible parameter combinations and therefore appears to be robust. Particularly in models with public services, this suggests that growth maximization may be a suitable second‐best strategy for benevolent governments. It occurs in part because the growth rate is a central determinant of welfare, but also because policy is relatively ineffective around the welfare and growth maxima. Hence, though previous models in the literature predict differences between welfare and growth maximization in a number of settings, we quantify these differences in our extended framework and show that differences in outcomes may be small. One inference is that in practice differences between growth and welfare maximization may not be a major concern such that some of the results in the existing literature overemphasize this dichotomy.

Misch, Florian, Norman Gemmell and Richard Kneller (2011), Growth and Welfare Maximization in Models of Public Finance and Endogenous Growth, ZEW Discussion Paper No. 11-041, Mannheim.