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Tax reform and public-sector expenditures

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Steven P. Cassou
Kevin J. Lansing

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Abstract

This paper evaluates the efficiency implications of various fundamental tax reforms in an infinite-horizon endogenous growth model with public-sector investment in human capital. A fully optimal reform requires the government to adjust its expenditures on education, training, or R&D, to take into account the tax incentives that are put in place to encourage private investment in these areas. So-called "revenue neutral" reforms (which address tax incentives but not public expenditures) can thus bring about a suboptimal mix of public and private investment in human capital. In quantitative simulation, we find that the appropriate size of government can be quite important for efficiency and that reforms which ignore this idea by maintaining public expenditures at pre-reform levels can miss out on a large portion of the available welfare gains from moving to a consumption-based tax system.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Papers in Applied Economic Theory and Econometrics with number 98-09.

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Date of creation: 2002
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Handle: RePEc:fip:fedfam:98-09

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Keywords: Human capital Income tax Tax reform Fiscal policy

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