Financing government expenditures in an open economy

Abstract

We study the growth and welfare effects of alternative modes of government finance within a small open economy. Using a model that allows for currency substitution and income-tax evasion, we find that seigniorage finance has stronger negative implications for growth over income-tax finance, in countries with less-developed financial markets. This result is reinforced when in these countries income-tax evasion is limited, a large share of foreign currencies is circulating, and when foreign currencies are close substitutes to the domestic currency. From a welfare perspective, the least distortionary method of financing a given amount of government expenditures is by means of income taxes.