Optimal Financing by Money and Taxes of Productive and Unproductive Government Spending: Effects on Economic Growth, Inflation, and Welfare

This paper contains an investigation of the effects of different means of financing government spending on economic growth, inflation, and welfare. In this setting, two different types of government spending are considered: productive expenditures which provide services to the private sector in its production activities; and unproductive expenditures which have no direct influence on the private economy. In turn, two different forms of finance are considered: proportional income taxation; and money creation. The primary result of the paper is, perhaps, striking in its simplicity. Specifically, we find that optimal public finance requires productive government to be financed by money creation and unproductive government expenditure by income taxation. Within the model structure–a representative agent, endogenous growth model with money introduced via a cash-in-advance constraint–the basic result is robust to changes in value of all underlying model parameters such as the intertemporal elasticity of substitution in consumption, the rate of time preference, and the output elasticity of public services. The paper proceeds as follows. Section II contains a brief description of the model. Section III presents the economic equilibrium, while Sections IV and V compare the effects of financing productive and unproductive expenditures, respectively, by taxation and money creation. Section VI brings together the previous sections considers the joint financing of government expenditures by taxation and money creation. Section VII concludes the paper and points to directions for future research.