Tax- versus Debt-Financing of Public Investment: A Dynamic Simulation Analysis

Tax- versus Dept-Financing of Public Investment: A Dynamic Simulation Analysis In this paper a two-period life cycle growth model is presented in order to illustrate the global effects of debt versus tax finance of public investment. Dynamic simulations are used to show how capital formation and the welfare of current and future generations are affected during the transition to a new equilibrium. It is demonstrated how economywide changes in real output and interest rates caused by an alternative choice between tax and debt financing of public investment affect the government’s budget constraint, a subject that has not yet been studied in detail in the prevailing literature. The results suggest that tax finance is superior to debt finance of public investment. In the long run, debtfinancing creates substantially higher crowding-out effects than does tax-financing of public investment. Negative short-run effects of tax-financing can be avoided by an efficient tax-transfer policy during transition periods, without lowering the long-run welfare gains of public investment policy