Government Budgetary Policies, Economic Growth, and Currency Substitution in a Small Open Economy

Abstract

This paper compares the macroeconomic consequences of alternative government budgetary policies in a small open economy where agents transact in both domestic and foreign currencies. An endogenous growth model is used to rank the effects of income-tax-financed and inflation-tax-financed government expenditures on the economy's growth and inflation rates. Currency substitution provides an avenue for inflation-tax evasion and affects the rankings of the two modes of government finance. The analysis reveals that an increase in the size of government reduces the growth rate of the economy regardless of the government's budgetary policy. Inflation taxes hinder growth more than income taxes. Income-tax financing is also the preferred policy in terms of its effect on the economy's inflation rate. Under the growth-maximizing tax mix, the government relies on both forms of finance but receives most of its revenue from income taxes.