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Optimal Policy under Restricted Government Spending

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  • Sørensen, Anders

    (Department of Economics, Copenhagen Business School)

Abstract

Welfare ranking of policy instruments is addressed in a two-sector Ramsey model with monopoly pricing in one sector as the only distortion. When government spending is restricted, i.e. when a government is unable or unwilling to finance the required costs for implementing the optimum policy, subsidies that directly affect investment incentives may generate higher welfare effects than the direct instrument, which is a production subsidy. The driving mechanism is that an investment subsidy may be more cost effective than the direct instrument; and that the relative welfare gain from cost effectiveness can exceed the welfare loss from introducing new distortions. Moreover, it is found that the investment subsidy is gradually phased out of the welfare maximizing policy, which may be a policy combining the two subsidies, when the level of government spending is increased. Keywords: welfare ranking, indirect and direct policy instruments, restricted government spending JEL: E61, O21, O41

Suggested Citation

  • Sørensen, Anders, 2006. "Optimal Policy under Restricted Government Spending," Working Papers 08-2006, Copenhagen Business School, Department of Economics.
    • Handle: RePEc:hhs:cbsnow:2006_008
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    Keywords

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    JEL classification:

    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • O21 - Economic Development, Innovation, Technological Change, and Growth - - Development Planning and Policy - - - Planning Models; Planning Policy
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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