Fiscal policy under a minimum‐time objective
| Published date | 01 July 2018 |
| Date | 01 July 2018 |
| DOI | http://doi.org/10.1111/sjpe.12153 |
| Author | Darong Dai |
FISCAL POLICY UNDER A
MINIMUM-TIME OBJECTIVE
Darong Dai*
ABSTRACT
In an endogenous growth model, we characterize the fiscal policy driven by a
minimum-time objective of economic development. We find that in equilibrium
government should levy the highest possible consumption taxes, reduce public
expenditures to the lowest possible level, and keep labor income tax rate and
capital income tax rate satisfy a substitution relationship at the balanced budget
constraint. We also identify the condition under which income tax rate should be
set to zero. We further find that the equilibrium fiscal policy is equivalent to the
growth-maximizing fiscal policy, whereas it generally deviates from the welfare-
maximizing fiscal policy. We hence identify a circumstance where setting the
policy goal of reaching an economic-performance target as soon as possible can-
not be justified in the sense of maximizing the welfare of households.
II
NTRODUCTION
In real-world settings, instead of maximizing the welfare of households, fiscal
policy can be driven by economic efficiency through reaching high-perfor-
mance goals. In fact, this kind of motivation can be illustrated by the follow-
ing examples. First, in order to exit an economic crisis or economic recession
as soon as possible, governments may implement fiscal policy which involves
reaching economic-performance targets subject to fiscal-expenditure require-
ments.
1
Second, as empirically demonstrated by Brender and Drazen (2008),
strong macroeconomic performance, reflected in higher growth rates of real
GDP per-capita, is associated with a higher probability of reelection in less
developed countries and in new democracies, so incumbent politicians may
use fiscal policy to boost economic performance in order to be re-elected in a
limited period. Third, some governments may need to reach some economic-
*Texas A&M University
1
For example, as an attempt to minimize the impact of the global financial crisis on Chi-
nese economy, the State Council of the People’s Republic of China announced a RMB 4 tril-
lion stimulus package on November 9, 2008.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12153, Vol. 65, No. 3, July 2018
©2017 Scottish Economic Society.
293
performance criteria quickly for joining certain economic unions, such as
WTO, APEC, EU, and the EMU.
2
The important issue of designing optimal fiscal policy for economic growth
and development has occupied the minds of economists for quite a while and
has been discussed from many different points of view. For example, some
classic endogenous growth models have stressed the role of fiscal policy as a
key determinant of long-run economic growth (see, Barro, 1990; Rebelo,
1991; Jones et al., 1993; Ireland, 1994; and Turnovsky, 1996). Even so, what
should be the appropriate objective function for the government in a given
developing economy? This is a disputable question from the perspective of
promoting long-term economic development. As a consequence, any chosen
objective or motivation should be supported by some reasonable justification.
In this paper we focus on a setting in which the government is motivated to
choose a fiscal policy, which consists of linear distortionary taxes and public
expenditures, to minimize the expected (or average) time needed to reach a
given development target of GDP per capita.
3
Holding the factor of income
inequality constant, we believe that GDP per capita is a reasonable indicator
for measuring the level of economic development. For instance, according to
the World Bank Classification of Country Income Groups for the 2016 fiscal
year, low-income economies are defined as those with a gross national income
(GNI) per capita, calculated using the World Bank Atlas method, of $1045 or
less in 2014; middle-income economies are those with a GNI per capita of
more than $1045 but less than $12,736; high-income economies are those with
a GNI per capita of $12,736 or more. Accordingly, we can interpret our speci-
fication as follows: low-income economies choose a fiscal policy to minimize
the expected time needed to reach the target of GNI per capita of $1045, and
middle-income economies choose a fiscal policy to minimize the expected time
needed to reach the target of GNI per capita of $12,736. Noting that there
are still over 130 countries classified as low-income and middle-income econo-
mies until 2016, we think that such a specification of reaching a desirable tar-
get in minimum time does capture realistic concerns, especially for the 31 low-
income economies.
To this end, we develop an endogenous growth model with a production
technology that is essentially an AK-type production function (see, e.g.,
Barro, 1990; Rebelo, 1991; Futagami et al., 1993; Rebelo and Xie, 1999;
Turnovsky, 2000; Dai, 2013) and also exhibits increasing returns to scale with
2
As is commonly recognized, the high speed of economic growth during the 1990s helps
China to become a member of WTO in 2001. In contrast, although Turkey makes every
effort to join EU (see sputniknews.com, December, 2015), Austria proposes a halt in Turkish
bid to join EU as it thinks that Turkey’s economy is not in line with EU standards (see sput-
niknews.com, April, 2016).
3
In addition, setting such an objective exhibits an important technical advantage. In the
context of the Chamley (1986) analysis, in which policymakers maximize social welfare, opti-
mal taxation involves finding the endogenous timing of switching from one tax boundary to
another, in a similar way that “bang-bang” solutions work. This is in general technically dif-
ficult to obtain analytical results. As pointed out by a referee, setting the current policy goal,
other than the conventional one, essentially boils down to an optimal timing question of
taxes as well.
294 DARONG DAI
Scottish Journal of Political Economy
©2017 Scottish Economic Society
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