The Optimal Public Expenditure Financing Policy: Does the Level of Economic Development Matter?

This paper explores how the optimal mode of public finance depends on the stage of economic development. The theoretical analysis is based on an overlapping generations growth model with an imperfect capital market. Random shocks create a demand for liquidity and establish a role for financial intermediaries. In this model, inflation matters because it affects the relative rates of return on assets in such a way that money becomes the preferred asset in the portfolio holdings of banks, causing a detrimental effect on economic growth. Such an effect is stronger (weaker) at lower (higher) levels of economic development due to the higher (lower) default risks associated with lending. Consequently, income taxation (seigniorage) is a relatively less distortionary way of financing public expenditure for low-income (high-income) countries. We provide empirical support for our model’s predictions using a panel of 21 OECD and 40 developing countries observed over the period 1972-1999.