Financial Deepening in a Two-Sector Endogenous Growth Model with Productivity Heterogeneity

We develop a tractable two-sector endogenous growth model in which heterogeneous entrepreneurs face borrowing constraints and the government collects tax to fund public eduction. This model is isomorphic to a Uzawa-Lucas model and there exists a balanced-growth path equilibrium in which the growth rate depends on the financial deepening level. We show that the policy tax rate exerts inverted U-shaped effects on the growth rate. Additionally, at the optimal policy tax rates the model's predictions are consistent with correlational regularities documented from 35 OECD countries with regards to financial deepening, factor accumulation and working hours.