Long-Run Growth Versus Welfare: The Importance of Transitional Dynamics When Assessing Alternative Fiscal Policies

41 Pages Posted: 20 Oct 2009 Last revised: 18 May 2011

See all articles by Manoj Atolia

Manoj Atolia

Florida State University - Department of Economics

Bassam R. Awad

Central Bank of Jordan

Milton H. Marquis

Florida State University - Department of Economics

Date Written: July 6, 2009

Abstract

This paper analyzes the effects of distortionary taxes on growth and welfare in an endogenous growth model with a public capital externality. The model is calibrated to the U.S. economy, and experiments are run under which the tax regime is shifted from the current mix of capital income, labor income, and consumption taxes to a fiscal policy regime with complete reliance on a single source of taxation, including lump-sum tax. We find that tax policy changes that induce higher growth rate do not necessarily result in higher welfare due to different transitory effects. In fact, a shift to capital income tax while delivering highest long-run growth results in lowest welfare. Furthermore, long-run gains take many years - a generation - to start getting realized. Among different sources of taxation, we find that, in the long run, complete reliance on a consumption tax dominates the current tax regime; however, the current tax regime dominates an exclusive labor income tax, which in turn is less welfare-reducing than an exclusive capital income tax. These results are due to the fact that taxes on labor income and capital income distort investment decisions in reproducible capital, i.e., human capital and physical capital, and therefore have cumulative effects that do not result from a tax on consumption. Unlike previous studies, we account for the welfare effects of transition using optimal decision rules all along the transition path.

Keywords: Endogenous growth, tax policy analysis, welfare, public capital, human capital

JEL Classification: O41, E62, H54

Suggested Citation

Atolia, Manoj and Awad, Bassam R. and Marquis, Milton H., Long-Run Growth Versus Welfare: The Importance of Transitional Dynamics When Assessing Alternative Fiscal Policies (July 6, 2009). Available at SSRN: https://ssrn.com/abstract=1336140 or http://dx.doi.org/10.2139/ssrn.1336140

Manoj Atolia (Contact Author)

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States
+1.850.644.7088 (Phone)
+1.850.644.4535 (Fax)

HOME PAGE: http://mailer.fsu.edu/~matolia/

Bassam R. Awad

Central Bank of Jordan ( email )

PO. Box 37
King Hussein Street
Amman, 11118
Jordan

HOME PAGE: http://myweb.fsu.edu/bawad/

Milton H. Marquis

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States

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