Productive Public Expenditure in a New Economic Geography Model

We pursue the question of whether and how differences in productive public expenditure impacts on industrial location. The public sector, which operates with a balanced budget constraint, finances its expenditures taxing residents' income. Since the introduction of productive public expenditure and taxation affects in opposite direction the industrial location, results are very sensitive to the specific parameter constellation assumed. That is, it is not straightforward that following an increase in productive public expenditure in a region, that region will necessarily enjoy stronger agglomeration. As a major contribution to the literature, our approach considers jointly two effects arising from public policy decisions on expenditure: the demand effect and the productivity effect. The interplay of these two effects determines the final impact of an increase in productive public spending in one region on the spatial distribution of firms. Furthermore, the latter result is influenced by the way in which tax payers of the two regions contribute to the financing of productive public expenditure. Finally, in the case of symmetric regions, the impact on welfare of an increase in productive public services is found to be positive under certain conditions