Optimal time-consistent fiscal policy in an endogenous growth economy with public consumption and capital

In an endogenous growth model where the fiscal authority cannot commit to policy decisions beyond the current period, we explore the time-consistent optimal choice for two policy instruments: the income tax rate and the split of government spending between utility bearing consumption and productive services to firms. We show that under the time-consistent Markov policy the economy lacks any transitional dynamics and there is local and global determinacy of equilibrium. For empirically plausible parameter values we find that the Markov-perfect policy implies a higher tax rate and a larger proportion of government spending allocated to consumption than those chosen under a commitment constraint. As a result, economic growth is slightly lower under the Markov-perfect policy than under the Ramsey policy, with growth under lump-sum taxes being highest. The implication of our results is that if the private sector is aware of the government’s inability to pledge future policy decisions, then the government should impose a slightly higher tax rate and devote a higher share of public resources to consumption, with a relatively low cost in terms of growth.