The Optimal Composition of Government Expenditure withTransfer Payments, Education Expenditure and a Public Good

This paper examines the optimal allocation of tax revenue among a universal transfer payment, a pure public good and expenditure on education. Using a single-period framework, education expenditure raises the productivity of individuals via a human capital production function. The social welfare function is based on individuals’ (indirect) utilities. Education creates a substantial fiscal spillover whereby the increase in human capital gives rise to higher labour earnings and thus higher income tax revenue, thereby allowing greater government expenditure on all items than would otherwise be possible. A higher inequality of exogenous ability levels is found to increase all types of expenditure, but only the transfer increases in relative terms. Higher inequality aversion leads to an increase in transfer payments in absolute and relative terms, at the expense of the other two components. However, the effects are small so that different judges may display little disagreement concerning optimal expenditure shares. An increase in the elasticity of the wage with respect to basic ability implies that education is less effective in raising the average level of productivity, which leads to the planner reducing education spending which leaves more tax revenue available for spending on transfer payments and the public good.