Abstract
In this study, we consider a scenario in which the government resorts to an income and inflation tax to finance its expenditures in the money-in-the-production-function model. We show that a financing shift from the inflation tax to the income tax increases the real money holdings-to-capital ratio because the accumulation of capital is less favorable than holding money. We also find that a country’s economic growth rate is maximized if all government expenditures are financed through an income tax. For welfare maximization, the government should set the income tax rate higher than the growth maximizing tax rate and reimburse the excess revenue using money contraction.
Highlights
Since the pioneering work on the endogenous growth theory by scholars, such as Romer [1] and Lucas [2], the effect of taxation on economic growth has been one of the most carefully examined topics in the field of economics
We show that a financing shift from the inflation tax to the income tax increases the real money holdings-to-capital ratio because the accumulation of capital is less favorable than holding money
We find that the financing shift from the inflation tax to income tax increases the real money holdings-to-capital ratio for a given share of government expenditure
Summary
Since the pioneering work on the endogenous growth theory by scholars, such as Romer [1] and Lucas [2], the effect of taxation on economic growth has been one of the most carefully examined topics in the field of economics (for example, Rebelo [3] and Jones et al [4]). The related topic of the effect of different government expenditure financing on economic growth and welfare has been examined extensively in the literature, including Grinols and Turnovsky [5], Turnovsky [6], Palivos and Yip [7], Pecorino [8], and Gokan [9]. Another distinctive feature of our paper is that we use the money-in-theproduction-function (MIP) model. The firm compares the after-tax marginal product of each input to its rental rate, r (t ) or R (t )
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