Tax reform with useful public expenditures

This paper examines the economic effects of tax reform in an endogenous growth model that allows for two types of useful public expenditures; one type contributes to human capital information while the other provides direct utility to households. We show that the optimal fiscal policy calls for full expensing of private investment which shifts the tax base to private consumption. The efficient levels of public investment and public consumption relative to output are uniquely pinned down by parameters that govern both technology and preferences. In general, implementing the optimal fiscal policy requires a change in the size of government. If a tax reform holds the size of government fixed to satisfy a revenue-neutrality constraint, then the reform will be suboptimal; theory alone cannot tell us if welfare will be improved. For some calibrations of the model, we find that commonly-proposed versions of revenue-neutral tax reforms can result in large welfare gains. For other quite plausible calibrations, the exact same reform can result in tiny or even negative welfare gains as the revenue-neutrality constraint becomes more severely binding. Comparing across calibrations, we find that the welfare rankings of various reforms can change, depending on parameter values. Overall, our results highlight the uncertainty surrounding the potential welfare benefits of fundamental U.S. tax reform.