Consumption tax and productive government expenditure in DSGE model

Abstract

Our article presents a dynamic stochastic general equilibrium (DSGE) model to derive effects of a consumption tax rate increase. In the DSGE model, money and inflation are examined to elucidate the transitional path of policy. Results of a consumption tax rate increase are intuitive: GDP declines because of lower aggregate consumption. With a consumption tax rate increase, we consider the productive government expenditure model. In the standard DSGE model, the production function comprises inputs of capital stock and labor. Policy can change the capital stock and labor inputs to alter the production level. However, the production level can be changed by other policies. For instance, increased public investment in infrastructure by government can change the production level. After setting the DSGE model with productive government expenditure, we attempt derivation of a result. We consider the case in which additional productive government expenditure is financed by a consumption tax. In this case, compared with the case of a consumption tax increase without productive government expenditure, GDP increases even if the consumption tax rate is raised. An increase in productive government expenditure increases marginal labor productivity, thereby raising the wage rate. Consequently, by virtue of a raised wage rate, consumption can increase even if the consumption tax negatively affects aggregate consumption.